The Canadian courts have recently considered appeals of several cases in which the Crown has invoked the general anti-avoidance rule (GAAR) to challenge tax avoidance transactions. In Lehigh Cement, the Crown was unable to apply the GAAR because it could not meet its burden of establishing the taxpayer’s abusive tax avoidance in the context of planning that had interest paid (free of withholding tax) to an arms-length bank in respect of principal owed to an affiliated corporation. In Collins & Aikman, the Crown was similarly unable to meet its burden in seeking to apply the GAAR to the tax benefits obtained from planning in an unusual fact pattern (a non-resident’s investment in a Canadian operating company was held through a Canadian incorporated holding company that was a non-resident of Canada).
Both Antle and St. Michael Trust Corp. (Garron) involved planning that intended to see capital gains on shares of Canadian corporations realized without Canadian tax by trusts resident in Barbados. In Antle, the gain was taxed in Canada on the basis that the relevant shares had never been transferred to the purported non-resident trust. The case is important for the Federal Court of Appeal’s obiter comments which may breathe new life into the doctrine of sham in tax avoidance cases. In St. Michael Trust Corp., the trust was taxed in Canada on the basis that it was, in fact, a resident of Canada. The case is important for the new ground it breaks in this area. Neither Antle nor St. Michael Trust Corp. applied the GAAR. However, the Federal Court of Appeal in St. Michael Trust Corp. did confirm (in obiter) that, had the trust been a non-resident of Canada, the GAAR would not have applied to deny the treaty benefit.
Lehigh Cement Ltd. v. The Queen
Lehigh borrowed money from a consortium of Canadian banks. A related Belgian corporation acquired Lehigh’s debt, and Lehigh remitted withholding tax on interest payments. The terms of the debt were later amended to change the interest rate to the then market rate, and to add terms to comply with the former “5/25” Canadian domestic non-resident withholding tax exemption for interest on certain arm’s length corporate debt. The Belgian corporation then sold all of its right to interest payable on the debt to an arm’s length Belgian bank. Following the restructuring, Lehigh paid directly to the Belgian bank all interest payable on the Lehigh debt and did not withhold on the basis that the 5/25 exemption applied.
The Crown argued that there was a misuse of the 5/25 exemption as it was not intended to benefit a non-resident person who was legally entitled to be paid interest on a debt as a result of a transaction by which the right to be paid the interest is split from the right to be paid the principal amount.
Since the restructured loan did not result in Lehigh accessing funds in the international capital markets, the Crown argued that it was inconsistent with the underlying rationale of the exemption. The Tax Court agreed that the GAAR applied; the 5/25 exemption had been abused because Lehigh had not borrowed money from the Belgian bank or any other non-resident lender.
The Federal Court of Appeal reversed the Tax Court’s decision, concluding that the GAAR did not apply. The wording of the exemption was broad enough to include any interest payable by a Canadian resident corporation to a non-resident, “no matter how the non-resident may have become entitled to receive that interest”. The exemption required the arm’s length test to be met only in respect of the relationship between the person required to pay the interest and the person entitled to be paid the interest, and not in respect of the relationship between the person required to pay the principal amount of the debt and the person entitled to be paid the principal amount of the debt.
The Crown’s reliance on a single sentence in the 1975 budget papers was considered by the Court to be a “shaky foundation” and an insufficient basis on which to apply the GAAR to the restructuring of the Lehigh debt. The Crown’s argument found no other support in either the Act, the jurisprudence or any other authority. The Court noted that the Crown could meet its burden of proving a misuse by simply asserting that the transaction was unforeseen or exploited a legislative loophole.
On November 4, 2010, the Supreme Court of Canada denied the Crown’s application for leave to appeal the Federal Court of Appeal decision.
The Queen v. Collins & Aikman Products Co.
The Collins and Aikman multinational group reorganized its Canadian business operations so that it held directly a Canadian affiliate, Holdings, which in turn wholly owned another Canadian affiliate (CAHL). The reorganization resulted in the creation of both paid-up capital and adjusted cost base in the shares of Holdings held by the taxpayer of $167 million (a significant increase over the $425,000 which the taxpayer had before the reorganization in CAHL, the non-resident holding company for its Canadian operations). It was admitted the reorganization was carried out to permit tax-free returns of capital in the future.
The Tax Court of Canada held that the GAAR did not apply, as there was no abusive tax avoidance. The Court concluded that the Crown was unable to establish, through the use of extrinsic aids or relevant statutory provisions, that there is a general scheme of the Act that corporate distributions must be included in income except where specific provisions provide otherwise, or that there is a clear scheme against all forms of dividend stripping. The impugned transactions had real Canadian tax consequences, they did not rely on any specific provisions of the Act to accomplish what the provision sought to restrict, and they did not defeat the underlying rationale or purpose of any of the specific provisions that applied or were relied upon. Further, each of the steps in the reorganization was appropriate, and none were abusive, vacuous or artificial.
While not pleaded by the Crown, the Tax Court also considered whether section 212.1 was avoided and whether the avoidance was abusive. Although the reorganization’s success depended upon the non-application of section 212.1, which would have ground the paid-up capital of the CAHL shares from $167 million to $475,000, the Court was unable to conclude that the application of section 212.1 was avoided as part of the series of reorganization transactions because CAHL became non-resident many years prior to the reorganization.
The Tax Court concluded that consistency, fairness and predictability would be significantly eroded if the GAAR were to be lightly applied and upheld, and cautioned that the GAAR should not be used to fill in what the government perceives to be a possible gap left by the legislation.1
The Crown’s appeal of the Tax Court’s decision was dismissed by the Federal Court of Appeal in a brief decision delivered by Sharlow, J. from the bench. In addition to finding that the Tax Court had made no error that warranted intervention, the Court addressed the Crown’s argument, raised for the first time, that the reorganization transactions were abusive based on the inclusion of section 212.1 as part of the relevant statutory scheme for determining whether there was abusive tax avoidance under the GAAR. The Court agreed with the Tax Court’s conclusion that there was no abusive avoidance of section 212.1 since CAHL became nonresident in 1961, long before the occurrence of the reorganization transactions and the introduction of section 212.1 to the Act.
Consistent with Lehigh Cement, the Federal Court of Appeal’s decision emphasizes that the Crown must meet its evidentiary burden not only in alleging the taxpayer’s misuse or abuse based on the purpose of the relevant statutory provision(s) or the Act as a whole, but also in establishing such purpose in the first instance. In this case, the Crown was unable to convince the Court that there was a general scheme of the Act against dividend stripping that supported the application of the GAAR on the facts.
The Crown did not seek leave to appeal the Federal Court of Appeal’s decision to the Supreme Court of Canada.
Antle v. The Queen 3
The Canadian resident taxpayer implemented a series of transactions known as a “capital property step-up strategy”. The strategy involved transferring corporate shares owned by the taxpayer (and having an accrued gain) on a tax-deferred basis to a Barbados trust settled by the taxpayer for the benefit of his wife. The trust then sold the shares to the wife triggering the capital gain. The wife, in turn, sold the shares to a third party purchaser and used the proceeds to pay the trust for the shares. The trust then distributed the proceeds as trust capital to the wife, and then dissolved. If successful, the result would have been to shift a capital gain of the taxpayer taxable in Canada to a Barbados trust that would be exempted from Canadian tax on its gain under the Canada-Barbados Income Tax Convention (the Barbados Treaty).2
The Tax Court denied the taxpayer’s appeal from the Minister’s assessment for the capital gain arising on the share sale. From the evidence it was unclear when the Barbados trust deed was actually signed by the taxpayer and the trustee, when the Barbados trust was actually formed and when the share transfers occurred. The Tax Court found that the trust was not properly constituted and that the shares were never legally transferred to the Barbados trust. As a result, either the taxpayer had sold the shares to his wife and realized a capital gain on the sale, or he had transferred the shares to his wife on a rollover basis and was attributed the capital gain realized when his wife sold the shares.
In the alternative, the Tax Court held that the GAAR applied to the transactions. In the Court’s view, the underlying rationale of the capital gains exemption in the Canada-Barbados Income Tax Convention was frustrated, not with respect to the Barbados trust, but with respect to the taxpayer who used the treaty to avoid taxation, thus circumventing a general objective of the treaty to prevent tax avoidance. The Court held that the transactions abused both the Act and the treaty and the GAAR was applied to deny the taxpayer the benefit of the spousal rollover on the transfer of the shares to the Barbados trust.
The Federal Court of Appeal dismissed the taxpayer’s appeal in a brief judgment. Reviewing the case law, the Court concluded that the Tax Court did not err in looking beyond the terms of the trust deed at the taxpayer’s actions and all of the surrounding circumstances to determine whether the requisite intention to settle the Barbados trust existed.
However, the Court noted that, in its view, the Tax Court had misconstrued the intentional deception test required to establish that the Barbados trust was a sham. It was not necessary to conclude that there was a criminal intent to deceive: the test required only that the parties to a transaction present it differently from what they know it to be. Since the Tax Court had found as a fact that both the taxpayer and the trustee knew with absolute certainty that the trustee had no discretion or control over the shares, yet both had signed the trust deed which stated the opposite, that finding was sufficient to hold that the Barbados trust was a sham. Thus, not only was the proper execution and timing of the transactions a problem in this case, but also the intent of the parties to create a valid trust relationship, which was the linchpin of the capital step-up strategy.
The Federal Court of Appeal chose not to express its views on the Tax Court’s alternative ground for dismissing the taxpayer’s appeal based on the GAAR. However, the Court did address the question in another offshore trust context in St. Michael Trust Corp. v. The Queen.
St. Michael Trust Corp. v. The Queen (Garron v. The Queen)
The Tax Court of Canada considered whether two Barbados trusts were entitled to claim the benefit of the capital gains exemption in the Barbados Treaty on their dispositions to an arm’s length purchaser of shares of two Canadian holding corporations which indirectly owned a Canadian automotive parts manufacturing and assembly business. The trusts were established in 1998 in the course of a reorganization of the share structure of PMPL Holdings Inc. (PMPL), which owned shares of a Canadian corporation that manufactured and assembled parts for the automotive industry. Prior to the 1998 reorganization, the shares of PMPL were owned equally by Mr. Dunin and a holding company that was wholly owned by Mr. Garron, Mr. Garron’s wife and the Garron Family Trust. Both Mr. Garron and Mr. Dunin were residents of Canada. The trusts were settled under Barbados law, one trust for the benefit of Mr. Dunin and his family, and the other trust for the benefit of Mr. Garron and his family. Both trusts were settled by a friend of Mr. Garron who was resident in St. Vincent, the sole trustee of both trusts was a corporation resident in Barbados which provided trustee services, and the protector of both trusts (who had the power to remove and appoint trustees) was another friend of Mr. Garron who was resident in St. Vincent.
As part of the reorganization of PMPL, the existing shareholders of PMPL exchanged their common shares for fixed value preference shares of PMPL. Each trust subscribed for shares of a newly incorporated Canadian corporation, with each corporation in turn subscribing for common shares of PMPL. The share subscriptions were transacted based on a valuation of the common shares of PMPL immediately before the reorganization of $50 million. In 2000, when each trust sold shares of its respective holding corporations to the arm’s length purchaser, PMPL was valued at approximately $532 million. Capital gains of over $450 million realized by the trusts on the share dispositions were not subject to Barbados income tax. As the shares sold were taxable Canadian property, amounts on account of potential Canadian tax on the capital gains were remitted to the Canada Revenue Agency under Canada’s reporting procedures in section 116 of the Act. The trusts filed Canadian income tax returns for the year of disposition and sought a refund of the remitted amounts based on the capital gains exemption in the Barbados Treaty. The Minister denied the trusts the benefit of the Treaty exemption and assessed the trusts in respect of their capital gains on the sale.
On appeal of the Minister’s assessments, the Tax Court held that the test for determining trust residence should not be based on a mechanical determination of the residence of the trustee(s), as the case of Thibodeau v. The Queen did not support such a test. Instead, the appropriate test should be consistent with the central management and control test in the corporate context, which requires a court to determine where a corporation is actually managed and controlled. The Court found on the facts that the trusts were resident in Canada when the shares were sold because general decision-making in respect of the trusts was carried out by Mr. Dunin and Mr. Garron, and not the trustee which played only a limited role executing documents and providing administrative services in respect of the trusts. As the trusts were found to be resident in Canada, the capital gains exemption in the Barbados Treaty did not apply to exempt the capital gains arising on the share dispositions from Canadian tax.
The Federal Court of Appeal dismissed the taxpayers’ appeal, agreeing with the Tax Court that a central management and control test should be applied in determining the residence of the trusts, and further concluding that the Tax Court made no error in determining, based on the facts presented at trial, that the trusts were resident in Canada at the time the shares were sold.
The Court then expressed its opinion on the Crown’s alternative arguments, which had been commented on by the Tax Court.
Assuming that the trusts were resident in Barbados (based on a residence of the trustee test), the Crown argued that section 94 of the Act deemed the trusts to be resident in Canada at the time the shares were sold and therefore precluded the trusts from relying on the capital gains exemption in the Barbados Treaty. The Federal Court of Appeal disagreed with the Tax Court’s interpretation of the contribution test in paragraph 94(1)(b) which requires the trust to have acquired property, directly or indirectly in any manner whatever from a Canadian resident beneficiary or a person related to that beneficiary. Since the Tax Court had found that the pre-reorganization value of the common shares of PMPL was substantially more than $50 million, the reorganization therefore shifted value from the holders of the preference shares of PMPL to the Canadian holding companies owned by the trusts. Accordingly, based on the principle in Canada v. Kieboom, the holders of the preference shares of PMPL had transferred property indirectly to the Canadian holding companies owned by the trusts. Further, contrary to the Tax Court’s view, that transfer was an indirect transfer of property “in any manner whatever” to the trusts as sole shareholders of the holding companies, as the words “directly or indirectly in any manner whatever” in paragraph 94(1)(b) were deliberately chosen by Parliament to “capture every possible means by which the wealth and income earning potential represented by the shares of a Canadian corporation can move to a non-resident trust from a Canadian resident beneficiary of the trust or a person related to that beneficiary”.
Nevertheless, if section 94 applied to the trusts, the Tax Court was correct to conclude that the exemption in the Barbados Treaty trumped section 94. Based on the principles established in Crown Forest, the trusts would not be considered to be residents of Canada for purposes of the Barbados Treaty as they would be liable to tax in Canada under section 94 only for specified purposes of Part I of the Act. As such, if the test for trust residence were the residence of the trustee, then the trusts would be entitled to the benefit of the capital gains exemption in the Barbados Treaty as Barbados residents.
Regarding the Crown’s alternative argument that the GAAR applied to the trusts to deny them the benefit of the capital gains exemption in the Barbados Treaty, the Federal Court of Appeal agreed with the Tax Court that the series of transactions that resulted in the trusts becoming entitled to the treaty capital gain exemption in the face of the application of section 94 was not a misuse or abuse of the Barbados Treaty. In that case, section 94 was not avoided and, since the trusts were resident in Barbados for purposes of the Barbados Treaty, they could not misuse or abuse the treaty by claiming the capital gains exemption.
The taxpayer has until January 16, 2011 to seek leave to appeal the Federal Court of Appeal’s decision to the Supreme Court of Canada.
The Supreme Court of Canada is scheduled to hear the taxpayer’s appeal from the Federal Court of Appeal decision in Copthorne Holdings v. The Queen on January 21, 2011. In Copthorne, a multinational group’s Canadian operations were reorganized, resulting in a $67 million increase in the paidup capital of shares in a Canadian corporation held by a non-resident corporation. The increase resulted from an amalgamation of a Canadian parent corporation with its Canadian subsidiary, which was structured as a horizontal rather than a vertical amalgamation to avoid the application of rules that would otherwise have eliminated the subsidiary’s paid-up capital on amalgamation. The shares of the amalgamated corporation were subsequently redeemed for an amount equal to the aggregate paid-up capital of the two predecessor corporations, resulting in no Canadian tax. The Federal Court of Appeal upheld the Tax Court of Canada’s decision that the GAAR applied on the basis that the non-resident shareholder had double counted a portion of its actual invested capital in the paid-up capital of the amalgamated corporation. In the Court’s view, the double counting was abusive of the statutory provisions in the Act pertaining to share redemptions, the computation of paid-up capital and the effect of an amalgamation on that computation.
The Copthorne decision will be of particular interest regarding the proper scope of a series of transactions and the application of the abusive tax avoidance test under the GAAR in a situation where a provision of the Act references another statute. This case focuses on the calculation of paid-up capital of a class of shares of a corporation under the Act, which employs as a starting point the determination of stated capital under the relevant provincial corporate law statute.