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This judgment deals with GAAR. The Federal Court of Appeal reversed the decision of the Tax Court of Canada which had previously allowed the appeal by Deans Knight Income Corporation (“Forbes”) on the basis that GAAR did not apply.
The story begins in 2007. Forbes was experiencing serious cash flow difficulties and began looking for ways to monetize the non-capital losses and other tax attributes it had accumulated, but could not use.
Forbes undertook a reorganization in which its shareholders exchanged their shares for shares of a newly incorporated company, “New Forbes”. Following this reorganization, the shareholders owned all the shares of New Forbes, which owned all the shares of Forbes.
Subsequently, Forbes and New Forbes entered into an agreement with Matco Capital Ltd. (“Matco”) which provided a framework to monetize Forbes’ tax attributes (the “Investment Opportunity”). Under the agreement:
- Forbes’ existing business (except for its tax attributes) would be transferred to New Forbes.
- New Forbes would be entitled to receive $3.8 million (with some potential upside).
- New Forbes would “turn the reins” of Forbes to Matco.
All this was to be achieved in a way that would not trigger the acquisition of control rules, which would have prevented the utilization of the losses:
- Matco would pay Forbes $3 million as consideration for a convertible debenture, convertible at Matco’s option into voting and non-voting common shares of Forbes, providing Matco with 79% of the equity and 35% of the votes on a fully diluted basis.
- As a result of the issuance of the debenture, the shares of Forbes that were owned by New Forbes would represent 21% of the equity and 65% of the votes on a fully diluted basis.
Matco would then use its expertise to arrange for a takeover of Forbes in an initial public offering (“IPO”) or similar transactions, again, to ensure that an acquisition of control did not take place (this time by a “group of persons”).
A few months after the agreement was entered into, Matco commenced negotiations with Deans Knight Capital Management Ltd. (“DK”) regarding a proposed takeover of Forbes by way of an IPO. Forbes changed its name to Deans Knight Income Corporation (“DKIC”) in February 2009. The IPO closed approximately a month later after raising $100 million, to be managed by DK and invested in corporate debt securities.
As a result of these transactions, Matco invested $3.8 million to own shares of Forbes, now DKIC, with a value of $5 million. New Forbes no longer owned any shares of DKIC and realized $3.8 million in the process. DKIC deducted the majority of its tax attributes from 2009 to 2012 to reduce its tax liability from the debt-securities business.
On July 16, 2014, the CRA reassessed DKIC for these four taxation years. DKIC appealed to the Tax Court of Canada and won. The Crown then appealed to the Federal Court of Appeal.
In addressing GAAR, Woods J.A. started by referencing the framework of analysis for GAAR laid out by the Supreme Court of Canada in Copthorne.[1] These three questions must be answered under section 245 [note that all legislative references in this post are to the Income Tax Act]:
- Whether there was a “tax benefit”.
- Whether the transaction giving rise to the tax benefit was an “avoidance transaction”.
- Whether the avoidance transaction that gave rise to the tax benefit was “abusive”.
The first two questions were not in dispute. There was a tax benefit consisting of DKIC’s use of the tax attributes to reduce its tax liability. The investment agreement, restructuring, all other related transactions and the IPO were avoidance transactions.
The key remaining point in contention was whether the relevant transactions were an “abuse”. In addressing this last point, Woods J.A. proceeded to determine the object, spirit and purpose or underlying rationale of subsection 111(5). (Whereas the parties also addressed subsection 256(8), Woods J.A. did not see the need to go there.)
She agreed with the Tax Court of Canada that the object, spirit and purpose of subsection 111(5) was “to target manipulation of losses of a corporation by a new person or group of persons, through effective control over the corporation’s actions”. However, she replaced the expression “effective control” by “actual control” in order to remove any ambiguity as to its meaning. Thus, Woods J.A. rearticulated the object, spirit and purpose of subsection 111(5) as “to restrict the use of specified losses, including non-capital losses, if a person or group of persons has acquired actual control over the corporation’s actions, whether by way of de jure control or otherwise.” [Emphasis added.]
In support of her view, Woods J.A. referred to a statement made by the Minister of Finance in 1963 that the purpose of the acquisition-of-control test was to stop a “practice [that] has developed of trafficking in the shares of companies whose businesses have been discontinued, but which technically have certain tax loss carry forward entitlements”. She also referred to an article published in the Canadian Tax Journal in 1988 wherein David Dodge, then a senior Department of Finance official, commented that one of the objectives of GAAR was to deal with an erosion of tax revenues, including a shortfall in expected tax revenues that “was considered to be caused largely by the unexpected application of loss carryforwards”. Lastly, referring to the Supreme Court of Canada, Woods J.A. noted that it has recognized that “the general policy of the Income Tax Act is to prohibit the transfer of losses between taxpayers, subject to specific exemptions” and “that this policy is to be taken into account in determining Parliament’s intent”.[2]
DKIC urged the Court to find that the object, spirit and purpose of subsection 111(5) was fully expressed in its text and restricted loss carryovers only if there is an acquisition of de jure control. In support of its position, DKIC referred “to the text of subsection 111(5), the history of the provision, the re-introduction of an equity test in 2013 in section 256.1, the extensive use of a de facto control test in the Income Tax Act (including the broad deeming rule introduced in 2017 in subsection 256(5.11)), and the restrictions in specified circumstances in subsection 256(7).” According to DKIC, these factors illustrate Parliament’s intention to allow loss carryovers, unless there was an acquisition of control that prohibits such carryovers. Woods J.A. disagreed. The fact that Parliament enacted several specific anti-avoidance rules that apply to a corporation with non-capital losses does not mean that they work together to provide a comprehensive scheme, nor does it reflect a policy that the GAAR has no application to them. While these anti-avoidance rules address specific circumstances, the GAAR provides a more comprehensive scheme that overarches these rules.
DKIC also argued that if the object, spirit and purpose of subsection 111(5) is determined to be broader than de jure control, the result would be a de facto control test. DKIC pointed out that since Parliament chose not to use the de facto control test in subsection 111(5), whereas it did in other parts of the Income Tax Act, this omission was purposeful. Woods J.A. refuted this argument as follows:
83 It is true that the object, spirit and purpose of subsection 111(5) as articulated above does include forms of de jure and de facto control. However, the actual control test is different than the statutory de facto control test in subsection 256(5.1) of the Act. Moreover, it must be remembered that the GAAR is intended to supplement the provisions of the Act in order to deal with abusive tax avoidance. I see nothing inconsistent with the conclusion that the object, spirit and purpose of subsection 111(5) takes into account different forms of control even though the text of the provision is limited to de jure control.
84 Reference may also be made to the Supreme Court’s decision in Duha Printers, in which the Court considered transactions designed to circumvent the de jure control test in subsection 111(5) of the Act. The Court commented that the de jure control test was selected “because in some respects it is a relevant and relatively certain and predictable concept to employ in determining control” (at para. 58). The Court also commented (at para. 52) that if the distinction between de jure and de facto control is to be eliminated, this should be left for Parliament.
85 Parliament did respond. While Parliament did not change the de jure control test in subsection 111(5), it did enact the GAAR to respond generally to abusive tax avoidance. I note that the GAAR was enacted a few years after the transactions in Duha Printers were implemented.
The Crown argued that “the object, spirit and purpose of subsection 111(5) engages circumstances where there is a lack of shareholder continuity. The focus is on a change of shareholders, not a change of control.” Woods J.A. decided not to address this argument since it was not necessary in reaching her conclusion.
Woods J.A. agreed with the Tax Court of Canada’s findings regarding the object, spirit and purpose of subsection 111(5) (which is subject to the correctness standard of review). Regarding the Tax Court of Canada’s findings on whether there was abuse with regard to the particular facts of the case (which is subject to the palpable and overriding error standard of review), Woods J.A. found that the conclusion reached by the Tax Court of Canada was inconsistent with the terms of the Investment Agreement. In view of all the restrictions contained in the Investment Agreement, New Forbes and Forbes/DKIC handed “actual control” over to Matco. They were not free actors, but instead were compelled into a certain course of action:
98 With respect, the Tax Court’s conclusion at step two is inconsistent with the terms of the Investment Agreement. These terms gave Matco actual control over the actions of the Respondent, including the approval of the Corporate Opportunity.
99 The Investment Agreement deals separately with control in general, and control over the approval of the Corporate Opportunity.
100 As for control in general, the Agreement provides severe restrictions on the actions that New Forbes and the Respondent may take (section 6.1 of the Agreement). The Agreement backs up these restrictions by providing that New Forbes’ entitlement to the additional $800,000 payment within one year (the Guaranteed Amount) will be forfeited if New Forbes does not comply with its obligations (section 8.3(a) of the Agreement).
[…]
102 As for terms in the Agreement relating to the approval of the Corporate Opportunity, the Agreement purports to allow New Forbes and the Respondent to accept or reject a Corporate Opportunity in their sole discretion (section 4.1 of Agreement). However, that is not the end of the matter. If a Corporate Opportunity is rejected by either New Forbes or the Respondent, the Guaranteed Amount is forfeited (section 5.5(d) of the Agreement).
Thus, in allowing the Crown’s appeal, Woods J.A. concluded that the Tax Court of Canada’s “error is palpable because it is plain to see that the Court’s conclusion is not consistent with the terms of the Investment Agreement and it is overriding because it affects the result.”
In this case, the parties acted in concert in order to take advantage of subsection 111(5) by adopting a narrow interpretation of that provision. However, the GAAR is there to expand on this narrow interpretation by forcing an analysis of the object, spirit and purpose of the provision.
[1] 2011 SCC 63.
[2] Mathew v. Canada, 2005 SCC 55.