On October 15 2012 the Federal Court of Appeal issued its latest decision under the general anti-avoidance rule (GAAR) in Triad Gestco Ltd v The Queen (2012 FCA 258). The taxpayer's capital loss was denied under the GAAR on the basis that there was no economic loss.
Although the legislation does not expressly state that a taxpayer must suffer an economic loss, the court read this requirement into the tax provisions that allow for a capital loss, stating that "the capital gain system is generally understood to apply to real gains and real losses".
The taxpayer realised a capital gain of C$8 million in its 2001 taxation year on the sale of a commercial building to an arm's-length party. The taxpayer then completed transactions in its 2002 taxation year designed to create an offsetting capital loss.
The taxpayer generated the capital loss by paying C$8 million to acquire common shares in a new corporation. The common shares had an initial fair market value and adjusted cost base to the taxpayer of C$8 million. The new corporation then declared a stock dividend that it paid by issuing preferred shares with nominal paid-up capital, but a redemption value of C$8 million, to the taxpayer. This shifted all the value of the new company from the common shares to the preferred shares. Since the shares had nominal paid-up capital, their adjusted cost base to the taxpayer was also nominal. Consequently, the taxpayer now held common shares with an adjusted cost base of C$8 million and nominal fair market value, and preferred shares having a nominal adjusted cost base but a fair market value of C$8 million.
After the value of the common shares was reduced to a nominal amount, the taxpayer sold the common shares to a trust settled (by an unrelated person) for the benefit of the taxpayer's majority shareholder. Since the taxpayer's C$8 million cost for the common shares exceeded the nominal sale proceeds received from the trust, a capital loss of C$8 million was created in circumstances where there was no economic loss. The taxpayer then sought to deduct the capital loss against the capital gain that it realised on the sale of the commercial building. The Canada Revenue Agency (CRA) applied the GAAR to deny the taxpayer's deduction of the capital loss on the basis that the taxpayer incurred no economic loss. In order for the GAAR to apply there must be a tax benefit, an avoidance transaction and an abuse of the specific tax provisions relied on by the taxpayer to achieve the tax benefit. Before the Federal Court of Appeal the only issue was whether the Tax Court of Canada was correct to conclude that the relevant provisions had been abused.
The Tax Court concluded that an abuse occurred because the transactions were undertaken to "defeat the underlying rationale of the capital loss provisions of the [Income Tax] Act", in part because "the appellant created artificially devalued property that was transferred to a person within the same economic unit to create an artificial capital loss without incurring any real economic loss".
The taxpayer argued that this conclusion was incorrect for reasons including the following:
- The presence of abuse must be determined based on the purpose of the specific tax provisions that give rise to the benefit, and the Tax Court failed to root its analysis in specific provisions.
- No general purpose of the Income Tax Act can be discerned allowing only for capital loss claims where there is an economic loss; in fact, several provisions deem a gain or loss to occur in the absence of an economic loss.
- The 'economic unit' concept should be rejected in the circumstances. Although a 2005 amendment would have caused the trust to be 'affiliated' with the taxpayer (with the result that the loss would be denied in the circumstances), these transactions occurred before 2005.
The Federal Court of Appeal concluded that the Tax Court's decision was correct, but for different reasons. The Federal Court of Appeal did not accept the concept of 'economic unit', noting that Parliament was aware that the concept of 'affiliated persons' did not include trusts when first enacted and, when this definition was amended to add trusts in 2005, the amendment was not made retroactive.
The Federal Court of Appeal agreed with the analysis of Justice Paris in the companion case 1207192 Ontario Limited v The Queen.(1), (2) It further agreed with Paris's conclusion that the relevant "provisions, in particular 38(b), provide relief as an offset against capital gain where a taxpayer has suffered an economic loss on the disposition of property". TheFederal Court of Appeal referred to the specific provisions that allowed for a capital loss to be deducted and stated that "[t]he result proposed by the appellant is fundamentally counter-intuitive as the capital gain system is generally understood to apply to real gains and real losses".
For authority in support of its position, the Federal Court of Appeal pointed to:
- the Carter Commission Report that pre-dated the introduction of the capital gain system; and
- House of Lords jurisprudence that supported reading the capital gain provisions as including the concept of economic loss.
After acknowledging that the legislation does not expressly include the phrase 'economic loss', the Federal Court of Appeal read the concept of economic loss into the relevant provisions, including Paragraph 38(b), stating: "Given their purpose – i.e. to tax the net realized increase in the value of capital assets – it is not possible, in my view, to read the provisions otherwise."
It is interesting to compare the Tax Court's abuse analyses in Triad Gestco (2011 TCC 259) and 1207192. Both cases involved similar facts and issues, and the taxpayer lost in both.
In the former case, however, Justice Favreau concluded that the object, spirit and purpose underlying the capital loss rules is to deny recognition of "artificial capital losses realized within the same economic unit". He reached this conclusion relying in part on the 'stop loss' rules in Paragraph 40(2)(g) and Subsection 40(3.4). Those rules apply to deny or suspend capital losses created in transactions between affiliated persons. The definition of 'affiliated persons' did not extend to trusts in 2002 (one of the years reassessed in Triad Gestco), but was amended to do so in 2005. It was common ground that the rules would have applied to the taxpayer in Triad Gestco if the 2005 amendments had been in force at that time. In effect, Favreau regarded the 2005 amendments as fixing an oversight in the original stop-loss rules.
Paris respectfully rejected this reasoning in 1207192. On his analysis, the various stop-loss rules in the Income Tax Act evidenced no general policy against losses realised between related parties, but rather "were intended to deny losses in the limited and specific circumstances set out in those provisions". In his view, the definition of 'affiliated persons' as it read in 2002 "sets out a carefully crafted group of relationships, and I believe that it is reasonable to infer that Parliament chose to limit the scope of the definition accordingly". In effect, Paris regarded the 2005 amendments as signifying a change in policy, not a repair of defective rules. Those rules did not extend to trusts in 2002, and therefore the GAAR should not apply to deny the taxpayer's capital loss realised in that year on a disposition to a trust merely because the same transaction would have been subject to the stop-loss rules as subsequently amended. However, Paris did conclude that the rules allowing the deduction of capital losses were intended to apply only to real economic losses suffered by a taxpayer. In reaching this much more circumscribed conclusion, he relied in particular on comments in:
- the 1966 Carter Commission Report;
- former Section 55(1) (denying artificial or unduly created capital losses), which was repealed in 1988 in conjunction with the enactment of the GAAR; and
- the Department of Finance's Technical Notes which accompanied the original introduction of the GAAR.
In Triad Gestco the Federal Court of Appeal explicitly accepted the reasoning of Paris over that of Favreau: the GAAR applies because the taxpayer suffered only a 'paper loss' without any real economic loss, and not because there is an overarching policy in the Income Tax Act which denies losses incurred within the same economic unit.
The result was the same to the taxpayer: it lost. Unless overturned on appeal, however, the case remains a salutary reminder that:
- the CRA must prove that any alleged abuse under the GAAR is firmly rooted in a proper textual, contextual and purposive interpretation of the specific provisions relied on by the taxpayer to achieve the tax benefit in question; and
- the GAAR ought not to be used as a sort of retroactive amendment tool.
On appeal, the taxpayer argued that disallowing the capital gain would be unfair, as it would realise a capital gain equal to the denied capital loss on its ultimate disposition of the preferred shares. The Federal Court of Appeal gave this argument short shrift, noting simply that the taxpayer had suggested no "credible scenario" in which the preferred shares would be sold – had it done so, a court might have had some basis to adjust the consequences of the application of the GAAR as permitted under Subsection 245(5). However, since no scenario was advanced, no further relief under that provision was granted.
This case provides authority that the Canadian system of taxing capital gains and losses, and Paragraph 38(b) in particular, must be read knowing that 'economic loss' is an unwritten aspect of the system that must be considered in tax planning. The result is in contrast to the Supreme Court of Canada's seminal decision under the GAAR, Canada Trustco Mortgage Co (2005 SCC 54), where the Supreme Court declined to read the concept of economic cost into the provisions that allow for a deduction of capital cost allowance.
The taxpayer has until December 14 2012 to apply for leave to appeal to the Supreme Court of Canada.
For further information on this topic please contact Richard J Bennett at Borden Ladner Gervais LLP's Vancouver office by telephone (+1 604 687 5744), fax (+1 604 687 1415) or email (firstname.lastname@example.org). Alternatively, contact Patrick Lindsay at Borden Ladner Gervais's Calgary office by telephone (+1 403 232 9500), fax (+1 403 266 1395) or email (email@example.com).
(2) In another case involving a similar issue, Global Equity Fund Ltd v The Queen (2011 TCC 507), the taxpayer was successful at the Tax Court of Canada. This decision was appealed to the Federal Court of Appeal but a decision had not been released at the time of writing.
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