Canadian courts have held that an increase to a corporate tax attribute does not constitute a tax benefit under the General Anti-Avoidance Rule (GAAR) even when the increase sets the table for a non-corporate shareholder to avoid tax in an abusive manner. Instead, when a series of transactions involving the corporation and non-corporate shareholders results in the non-corporate shareholders avoiding tax, the tax benefit only arises in the last step, e.g., when the non-corporate shareholders use the increased corporate tax attribute to withdraw funds from the corporation at a reduced rate of tax. This raises the question of whether there is value in increasing a corporate tax attribute – in setting the table – if the non-corporate shareholder cannot realize the value without the realization being a tax benefit under the GAAR.
What is GAAR?
GAAR is an anti-avoidance measure that the CRA uses to combat abusive tax avoidance strategies that are not subject to specific anti-avoidance rules in the Income Tax Act (ITA). Three elements must exist before the GAAR applies:
- There must be a tax benefit that is the result of a transaction or a series of transactions.
- The transaction – or a transaction within the series of transactions – is an avoidance transaction (the primary purpose of the transaction was to avoid taxes).
- The avoidance is abusive, meaning it cannot be reasonably concluded that the tax benefit obtained was consistent with the object, spirit or purpose of the provisions relied on by the taxpayer.
The threshold for finding a tax benefit in the GAAR analysis is very low. The ITA defines a tax benefit as any ‘reduction, avoidance or deferral of tax or other amount payable, or an increase in a refund of tax or other amount.’ Historically, it has been rare for the courts not to find a tax benefit. In fact, taxpayers often conceded the existence of a tax benefit in GAAR appeals and, instead focused on whether the avoidance transactions resulted in abusive tax avoidance.
One of the reasons the threshold for finding a tax benefit is low is because the ITA dictates that a “series of transactions” must be interpreted broadly. In fact, a subsequent transaction or event is deemed to part of the series even if the decision to complete the subsequent transaction is not made at the time of the original series. There does not need to be a strong nexus between the subsequent transaction that gives rise to the tax benefit and the original series of transactions that set the table. Instead, a tax benefit will be found to exist is the subsequent transaction is completed because of the original series.
Increases to corporate tax attributes are not tax benefits
Recent cases have established that increases to corporate tax attributes, such as the paid up capital of corporate shares or a corporation’s capital dividend account, do not constitute tax benefits under the GAAR.
Paid up capital (PUC) is the amount a shareholder can withdraw from a corporation as a tax-free return of capital. In theory, the PUC is equal to the amount of capital a shareholder contributed to the corporation. However, if, through a transaction or series of transactions, the PUC of corporate shares is increased beyond the amount contributed by the shareholder, and no existing legislation results in a PUC reduction, the shareholder would be entitled to tax-free withdrawals in excess of the capital the shareholder contributed. In 1245959 Alberta Ltd. v. Canada, the corporate taxpayer completed a series of transactions that inflated the PUC of shares held by an individual, but the corporation did not make tax-free distributions to the non-corporate shareholder. At the Tax Court of Canada (TCC) and Federal Court of Appeal (FCA) hearings, the corporate taxpayer conceded the existence of a tax benefit, however, the FCA refused to accept the appellant’s concession. The FCA held that a tax benefit did not arise unless and until the non-corporate shareholder received the tax-free distribution. In other words, the increase to the PUC of the shares did not result in a reduction of tax or an increase in a refund of tax.
The capital dividend account (CDA) is a notional account that tracks various tax-free amounts that a private corporation receives and can distribute to a non-corporate shareholder tax-free. Normally, a non-corporate shareholder has to include dividends in taxable income and, therefore, the CDA is extremely valuable. Two recent cases confirm that an increase to the CDA is not a tax benefit. In Rogers Enterprises (2015) Inc. v. The Queen, the appellant corporation used a series of transactions to add the full amount of life insurance proceeds to its CDA. The TCC held that the increase in CDA was not a tax benefit because it did not represent an increase in a refund under the ITA. In Gladwin Realty Corporation v. The Queen, the appellant corporation temporarily doubled its CDA and paid the CDA to a corporate shareholder while it was doubled, thereby allowing the corporate shareholder to receive in its own CDA account an amount that was double what it would have otherwise received. The FCA held that doubling of the CDA was not a tax benefit (just as the TCC held in Rogers Communications) and, instead, that the tax benefit would only occur when the CDA balance was paid to non-corporate shareholders. At the FCA hearing, Gladwin Realty undertook to pay the CDA to non-corporate shareholders, thereby conceding the existence of a tax benefit, so that the FCA would consider whether the other elements of the GAAR applied to the series of transactions. With the tax benefit no longer being an issue, the FCA held that the GAAR applied.
However, setting the table by increasing tax attributes only appears to avoid the tax benefit definition when a corporation’s tax attributes are increased. In Fiducie Financiere Satoma v. The Queen the appellant, which was a trust, received dividends without paying tax because the ITA attributed the dividends to the corporate settlor of the trust. The trust could have distributed the funds to individual beneficiaries on a tax-free basis, but did not, as the funds remained in the trust at all relevant times. The corporate settlor did not pay tax on the dividends because inter-corporate dividends between connected corporations are tax-free. The Minister applied the GAAR, and the appellant trust argued that a tax benefit would only be realized if the trust were to make a tax-free distribution to the individual beneficiaries of the trust. The TCC and FCA disagreed, finding that the trust itself realized a tax benefit as soon as it received the dividends tax-free. A trust is a non-corporate shareholder and the trust itself received tax-free corporate distributions and, as a result, the courts did not need the trust to distribute the funds to an individual beneficiary to find the existence of a tax benefit. Therefore, this decision accords with the courts’ comments in Rogers Communications and Gladwin Realty that a tax benefit is realized when a non-corporate shareholder, including a trust, receives tax-free distributions from a corporation.
What is the practical result of setting the table?
If a tax benefit is realized as soon as a non-corporate shareholder withdraws corporate funds tax-free due to an increase to corporate tax attributes, as the FCA held in Gladwin Realty, is there any real value in setting the table for a tax-free distribution to non-corporate shareholders? The broad interpretation of “series of transactions” suggests that the eventual tax-free distribution will be considered part of the series of transactions that sets the table, even if the tax-free distribution occurs several years after the original series. In these circumstances, strategies to increase PUC, CDA and other tax attributes may not attract the GAAR on their own, but avoiding GAAR at the corporate level might be moot if the non-corporate shareholder cannot recognize value in a subsequent event without the value being a tax benefit under GAAR.