Over the years, taxpayers have developed different techniques for mitigating the potential application of the debt forgiveness rules contained in section 80 of the Income Tax Act (Canada) (Act) in the context of the sale of shares of a corporation with underwater debt owed to its parent.1 One of these techniques involves the subscription by the parent for additional shares of the corporation and the use of the subscription proceeds to repay the debt owed to the parent by the corporation. On a few occasions, the Canada Revenue Agency (CRA) has indicated that it would not apply paragraph 80(2)(g) of the Act in these circumstances, but that the general anti-avoidance rule (GAAR) would likely apply.2 In the recent case of Pièces Automobiles Lecavalier Inc. v. The Queen,3 the Tax Court of Canada (Court) had to consider this issue in a cross-border context. The decision is of particular interest for its analysis of the requirement under GAAR that the transaction giving rise to a tax benefit be an "avoidance transaction" within the meaning of subsection 245(3) of the Act.
Factual Background and Relevant Transactions
Historically, Pièces Automobiles Lecavalier (PAL) started out as a company owned and operated by the Fugère family, including Roger Fugère Jr. (Mr. Fugère), and was specialized in the recycling of auto parts in Quebec. In 2000, as part of its restructuring plan, Ford U.S., a corporation not resident in Canada, acquired PAL through its Canadian subsidiary, Greenleaf Canada Acquisitions Inc. (Greenleaf). PAL was eventually merged with Greenleaf and its business continued to be carried on through Greenleaf’s Quebec division.
In April 2002, Ford U.S. ceased its recycling activities and Mr. Fugère decided to acquire Greenleaf’s Quebec division. According to his testimony, Mr. Fugère was only interested in acquiring the Quebec assets, but Ford U.S. insisted on effecting the transaction as a sale of the shares of Greenleaf. In September 2002, after lengthy negotiations, the parties finally came to an agreement for the acquisition by 3929761 Canada Inc. (Acquisico), a corporation to be created (which later became the taxpayer), of all the shares of Greenleaf and a debt of approximately $24.5 million owing by Greenleaf to Ford U.S. for an aggregate amount of approximately $9.5 million. Prior to the acquisition, the following transactions were completed on October 15, 2002: Ford U.S. subscribed for additional shares of Greenleaf for approximately $15 million and Greenleaf used the subscription proceeds to repay a portion of the debt, thereby reducing the debt to $9.5 million. On December 2, 2002, Acquisico acquired from Ford U.S. all the shares of Greenleaf for $1 and the debt for approximately $9.5 million.
If Acquisico had acquired the shares of Greenleaf and the debt without first reducing the debt, the debt parking rules in subsections 80.01(6) to (8) of the Act would have applied since the debt would have been acquired for less than 80% of its principal amount. If Greenleaf had issued shares to Ford U.S. as consideration for the partial settlement of the debt, the debt forgiveness rules would have applied as a result of paragraph 80(2)(g) of the Act since the fair market value of the shares issued would have been less than the portion of the principal amount of the debt that was repaid. In both cases, this would have resulted in the loss of the tax attributes of Greenleaf and an income inclusion of $5.7 million for the taxpayer under subsection 80(13) of the Act.
The Minister of National Revenue (Minister) alleged that GAAR applied and considered that the taxpayer had realized a gain of approximately $15 million on the forgiveness of the debt. Applying the provisions of section 80 of the Act, the Minister reduced the taxpayer’s tax attributes and made certain adjustments to its taxable income for the taxation years 2002, 2004 and 2005.
Analysis Under GAAR
The Court (per Bédard J.) began its analysis with general comments on the application of GAAR. Notably, the Court restated that subject to GAAR, a taxpayer can legally arrange his affairs to minimize the tax payable.4 The Court also reiterated that GAAR should be used only as a tool of last resort.5
- Tax benefit
The taxpayer conceded the first requirement for the application of GAAR, namely, the existence of a tax benefit (i.e., in this case, the preservation of Greenleaf’s tax attributes which would have otherwise been reduced by the application of section 80 of the Act).
- Avoidance transaction
With respect to the second requirement, the burden was on the taxpayer to disprove the allegations made by the Minister to the effect that the two "clean-up transactions" (i.e., the share subscription and partial debt repayment) were avoidance transactions within the meaning of subsection 245(3) of the Act since they had no bona fide purpose and were undertaken only to obtain a tax benefit, namely the preservation of Greenleaf’s tax attributes. According to the Minister, these two transactions, together with the sale of the shares of Greenleaf, formed a series of transactions which gave rise to the tax benefit.
The taxpayer first argued that the two clean-up transactions were not part of the same series of transactions as the acquisition of the shares of Greenleaf since they were implemented and imposed by Ford U.S. with no possibility of negotiation by the taxpayer. Instead, there were two distinct series of transactions, each completed by different parties. The evidence submitted by the taxpayer consisted of (i) the testimony of Mr. Fugère and Mr. Lacombe, a Canadian tax accountant who has been working with the Fugère family for several years, and (ii) a document of two pages showing the steps for the clean-up transactions, which would have been sent by fax a few days after the parties reached an agreement in September 2002. These steps had never been discussed by the parties. According to Mr. Fugère and Mr. Lacombe, the reason why Ford U.S. insisted on a sale of shares was to realize its capital loss on the shares of Greenleaf for U.S. tax purposes, which would be available only if the clean-up transactions were completed.
The Court found that the evidence was not sufficient to discharge the taxpayer’s burden. According to the Court, it would have been desirable, even necessary, to have a representative of Ford U.S. testify that Ford U.S. had unilaterally dictated the terms and structure of the transaction. The only documentary evidence submitted by the taxpayer was the two-page document that was neither signed nor dated, and which the Court found to have relatively low probative value. The Court indicated that it would be surprising that a company of Ford U.S.’s size and status would have proceeded with a transaction of over $9 million and dictated its terms by faxing a very rudimentary two-page document to the purchaser. The Court, therefore, concluded that the clean-up transactions and the sale of the shares of Greenleaf formed part of the same series of transactions.
The taxpayer also argued that the clean-up transactions were undertaken for U.S. tax purposes and for reasons specific to Ford U.S., which constituted bona fide non-tax purposes under subsection 245(3) of the Act. The Court recognized that based on the wording of paragraph 245(3)(b) of the Act and the definition of "tax benefit" in subsection 245(1) of the Act, strictly U.S. tax reasons would, in and of themselves, constitute bona fide non-tax purposes, and that internal considerations, whether accounting, economic or other, may in certain circumstances constitute bona fide non-tax purposes. Therefore, if it was reasonable to consider that the clean-up transactions were undertaken primarily for U.S. tax purposes and reasons specific to Ford U.S., they would not constitute avoidance transactions. Again, the only evidence submitted by the taxpayer was the oral testimony of Mr. Lacombe and Mr. Brian Nerney, a former shareholder of a company acquired by Ford U.S. who entered into similar clean-up transactions with Ford U.S. Both witnesses testified that the clean-up transactions were completed by Ford U.S. for U.S. accounting and tax purposes. The Court could not accept their testimony on the basis that it constituted hearsay. The Court drew a negative inference from the fact that no person from Ford U.S. testified in support of the reasons for the clean-up transactions and no U.S. tax expert testified to speak to the U.S. tax consequences of the transactions. After a general review of the case law on the principle of negative inference, the Court concluded that it was justified to apply it in the present case on the basis that: (i) the evidence submitted to the Court was deficient and not credible, and (ii) the reasons given by the taxpayer to justify the absence of such crucial witnesses, namely the lack of cooperation by Ford U.S. and the high costs of bringing a witness to Canada, were not sufficient.6
In obiter, the Court commented on the fact that according to Mr. Lacombe and Mr. Fugère, the Canadian tax consequences of the transactions had not been contemplated until they received the two-page document from Ford U.S. The evidence showed that Mr. Lacombe was aware of the existence of the $24.5 million debt. According to the Court, it is unlikely that an experienced tax specialist did not have the reflex to further inquire when he knew that Acquisico was going to acquire the shares of Greenleaf and its debt for $9.5 million.
Such a situation would have alarmed any tax specialist about the potential application of the debt forgiveness rules. The Canadian tax consequences were too significant not to have been considered.
- Misuse or abuse
With respect to the third requirement for the application of GAAR, the Minister argued that the avoidance transactions circumvented the object and spirit of section 80 of the Act in general. When a debtor benefits from a forgiveness of debt, its economic power is increased by the amount of the debt. If it deducted expenses in computing its income, such expenses will, in reality, have cost it nothing. In this case, if the debt had not been forgiven in part by the injection of capital and the repayment before the sale, the debt parking rules in subsections 80.01(6) to (8) of the Act would have applied. The Minister also argued that the clean-up transactions resulted in a misuse of paragraph 80(2)(g) of the Act. For its part, the taxpayer argued that section 80 of the Act constitutes a very clear and complete code and for that reason, it is difficult to demonstrate that an underlying tax policy that goes beyond the wording of the Act exists. In addition, the taxpayer argued that there are two aspects to the underlying tax policy of the rules in section 80 of the Act: (i) the increase of economic power of the debtor, and (ii) the deduction for bad debt for the creditor. Here, since Ford U.S. did not claim any deduction for bad debt as a result of the forgiveness of the debt, there was no abuse of the object and spirit of section 80 of the Act.
Applying a textual, contextual and purposive analysis, the Court rejected the taxpayer’s argument that the object and spirit of section 80 of the Act is twofold. The provisions allowing the creditor to benefit from a deduction for bad debt apply in very specific situations, independently and in a context much broader than the context of section 80 of the Act. The Court found no symmetry between the two regimes. The Court then reviewed the object and spirit of the debt parking rules in subsections 80.01(6) to (8) of the Act and concluded that by making a "temporary" capital injection, the taxpayer artificially reduced the debt in order to meet the 80% test and thus avoid the debt forgiveness rules. In carrying out the transactions this way, the taxpayer benefited from a $24.5 million loan and discharged its obligation to pay an amount of $15 million while benefiting from the deduction of expenses with respect to the full amount of the loan. By undertaking the avoidance transactions, the taxpayer circumvented the application of sections 80 and subsections 80.01(6) to (8) of the Act. The Court found that the avoidance transactions were clearly abusive and the Minister was justified to apply GAAR.
Even if there was no misuse of sections 80 and subsections 80.01(6) to (8) of the Act, the Court held that the application of GAAR would still be justified because the avoidance transactions resulted in a misuse of paragraph 80(2)(g) of the Act. The purpose of this provision is to ensure that the debt forgiveness rules cannot be avoided by transforming a debt into shares having a lesser value. In this case, the additional shares of Greenleaf had full fair market value at the time of their issuance, but their value was reduced immediately after the repayment. Without GAAR, the Court recognized that the transactions would not have triggered the application of paragraph 80(2)(g) of the Act. By effecting the transactions in two steps rather than by directly converting the debt into shares, the taxpayer circumvented the application of 80(2)(g) of the Act and thus avoided the application of the debt forgiveness rules.
This decision will certainly have an impact on transactions implemented to mitigate the application of the debt forgiveness rules as it clearly establishes that these types of transactions can be subject to GAAR. Nonetheless, the Court made interesting comments to the effect that U.S. tax reasons and internal considerations, whether accounting, economic or other, may in certain circumstances constitute bona fide non-tax purposes. Given the clear lack of evidence, the Court had no choice but to conclude that the taxpayer had not discharged its burden to demonstrate that the clean-up transactions were undertaken primarily for non-tax purposes, but it may have reached a different conclusion in other circumstances.