A recent case suggests that the General Anti-Avoidance Rule (GAAR) may apply to complex tax planning if it is not supported by a commercial purpose.
The federal government in the 1980s introduced the GAAR, an anti-tax avoidance provision to be used as a last resort measure against abusive tax avoidance. In 2005, the Supreme Court of Canada (SCC) in the case Canada Trust Mortgage Co v. Canada (Mortgage Co) established a framework for how to apply the GAAR:
1. There must be a tax benefit that is the result of a transaction or a series of transactions.
2. The transaction is an avoidance transaction (the primary purpose of the transaction was to avoid taxes).
3. The avoidance is abusive. In clarifying the third part of the test, the SCC stated that “abusive tax avoidance” occurs when 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.
This test has resulted in significant amounts of judicial subjectivity and uncertainty for taxpayers.
Birchcliff Energy Ltd. v. The Queen
Recently, the Federal Court of Appeal (FCA) had an opportunity to provide further clarification on the application of the GAAR in the case of Birchcliff Energy Ltd. v. The Queen.
At issue in the original Tax Court of Canada (TCC) case (TCC Case) was whether the appellant company Birchcliff Energy Ltd. (Birchcliff) could claim the non-capital losses of another company, Veracel Inc. (Veracel), that had amalgamated into Birchcliff.
In 2005, Veracel and Birchcliff amalgamated to become the amalgamated appellant company Birchcliff. Immediately prior to the transaction, Veracel had various tax attributes, including a $16 million non-capital loss. Several steps were taken to facilitate the amalgamation. Most importantly, the issuance of Class B voting shares of Veracel were made available for sale. The Class B shares would be immediately converted to common voting shares of the amalgamated Birchcliff contingent on a successful amalgamation, or the shareholders would be refunded.
The appellant Birchcliff argued that the purpose of the issuance of Class B shares of Veracel was to raise capital for restarting a new business. However, Justice Jorré found that Birchcliff could have easily raised capital on its own without issuing the Veracel shares. Further, despite Veracel’s stated purpose for the amalgamation - to start a new business - evidence was given that Veracel in fact wanted to monetize its tax losses; Veracel issued a request for proposals to utilize its tax losses without any mention of pursuing any new ventures. At the same time, Birchcliff had no need for a corporate shell company like Veracel in its own ongoing business.
Abusive Tax Avoidance? - Tax Court Decision
The issue of whether there was abusive tax avoidance turned on the mechanics of the amalgamation transaction. Generally under ITA clause 256(7)(b)(iii)(B), a minority predecessor company is deemed to be acquired by a larger, unrelated company that it amalgamated with unless a very technical rule on control is applicable. Non-capital losses of the minority predecessor are typically extinguished on an acquisition of control, and thus unavailable to the acquiring company. In this case, if the exception in clause 256(7)(b)(iii)(B) did not apply, then Veracel, as the smaller predecessor company, would be deemed to be acquired on amalgamation, and its losses would not be available to the amalgamated Birchcliff.
Birchcliff argued that the amalgamation fell within the exception provided by clause 256(7)(b)(iii)(B) and that control of Veracel had not been acquired by Birchcliff. As explained by the TCC’s Justice Jorré:
The exception requires that one perform the following hypothetical exercise. One assumes that a single person, immediately after the amalgamation, acquired all the shares of the amalgamated corporation acquired by the shareholders of one particular predecessor corporation on the amalgamation. If that single person then controls the amalgamated corporation the exception applies and there is no deemed change of control of the particular predecessor corporation.
[…] because of the number of votes in the amalgamated company acquired by the Class B shareholders, under the hypothetical test in clause 256(7)(b)(iii)(B), if a single person had acquired all the shares of the amalgamated corporation acquired by the shareholders of Veracel, that person would have had control of the amalgamated corporation. As a consequence the exception in that clause applies and there was no change of control of Veracel immediately prior to the amalgamation.
Justice Jorré found that if Veracel had not “artificially” issued its Class B shares immediately prior to the amalgamation, there would have been a clear acquisition of control by Birchcliff making Veracel’s losses unavailable to Birchcliff. The fact that the “ephemeral” existence of the Class B shares were solely predicated on the amalgamation made them different from shareholders in the ordinary course of business. The TCC thus concluded that the spirit of the exception was not to cover contingent shareholders who were solely shareholders for the sake of the amalgamation. The arrangement of the transaction was abusive tax avoidance and the GAAR applied.
The Recent Federal Court of Appeal Decision
The only issue in the appeal was whether the transaction was indeed abusive.
The FCA observed that Veracel would not have been allowed to retain the money raised by the Class B shares if the amalgamation was unsuccessful, suggesting that the resulting amalgamated entity did not intend to have two separate lines of business. Further, at that point, Veracel had neither assets nor employees and did not show any signs of continuing its activities. The court deduced that Birchcliff had thus in fact acquired control of the company even if the Class B shares made it seem otherwise under clause 256(7)(b)(iii)(B).
The FCA acknowledged that even though on the plain reading of clause 256(7)(b)(iii)(B) Birchcliff satisfied the criteria, the SCC emphasized that in applying the GAAR, a court should strive to capture the underlying rationale of transactions beyond the bare meaning of the words. On this basis, the FCA agreed with the TCC and concluded that there had been abusive tax avoidance. Therefore, the GAAR applied and Birchcliff was not entitled to claim Veracel’s non-capital losses.
The FCA’s decision suggests that companies should carefully consider structuring transactions in an overly mechanical manner without any obvious commercial purpose, as such transactions could be considered abusive tax avoidance.