THE CURRENT STATE OF GAAR: WHAT TO ANTICIPATE AFTER OVERS AND LIPSON? Jerry Wise, CA

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THE CURRENT STATE OF GAAR: WHAT TO ANTICIPATE AFTER OVERS AND LIPSON?

Jerry Wise, CA

Montreal, June 2006

RSM Richter is an independent member firm of RSM International, an affiliation of independent accounting and consulting firms.

RSM Richter est un cabinet indépendant membre de RSM International, association de cabinets indépendants d’expertise comptable et de services conseils.

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0GENERAL ANTI-AVOIDANCE RULE:

RECENT DEVELOPMENTS

• After the Supreme Court waded into the General Anti-Avoidance Rule (GAAR) in The Queen v. Canada Trustco Mortgage Company and Matthew (Kaulius) v. The Queen, some lower court decisions (notably Evans v. The Queen) seem to appropriately follow the guidelines set out by the Supreme Court.

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0OVERS v. LIPSON

• However, two recent GAAR decisions of the Tax Court, Overs v. The Queen and Lipson v. The Queen have similar facts but were decided differently.

• Both cases involved spousal transfers and attributed income or losses and had similar series of transactions and flow of funds.

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0OVERS v. LIPSON: THE FACTS

THE FACTS IN OVERS: THE FACTS IN LIPSON:

Mr. O had borrowed $2.3 million from his company, Oco for personal purposes.

Mr. and Mrs. L agreed to acquire a house for $750,000.

Mr. O needed to obtain money to repay the loan.

Mr. and Mrs. L needed to obtain money to acquire the house.

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0OVERS v. LIPSON : THE FACTS (Cont’d)


Mrs. O borrowed $2.3 million to acquire $2.3 million of common shares of Oco from Mr. O at FMV.

Mrs. L borrowed $562,500 to acquire $562,500 of common shares of Mr. L’s company (Lco) from Mr. L at FMV.

Mr. O used proceeds to repay Oco, thus avoiding the application of 15(2) ITA.

Mr. L used the proceeds to acquire the house, but at the same time, Mr. L and Mrs. L borrowed $562,000 on security of the house to repay the first loan.

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An election under 73(1) ITA was not made with the result that Mr. O was deemed to dispose of his shares of Oco at their cost amount.

An election under 73(1) ITA was not made with the result that Mr. L was deemed to dispose of his shares of Lco at their cost amount.

Notwithstanding that Mrs. O paid FMV for the shares of Oco, 74.5(1)(c) ITA did not apply to prevent the attribution rules from being applicable (due to 73(1) ITA).

Notwithstanding that Mrs. L paid FMV for the shares of Lco, 74.5(1)(c) ITA did not apply to prevent the attribution rules from being applicable (due to 73(1) ITA).

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No dividends were declared. No dividends were declared in first year, but dividends were declared in next 2 years.

Mr. O deducted as a loss from the shares the interest expense and guarantee fees paid by Mrs. O which were attributed back to him.

Mr. L deducted as a loss from the shares the excess of the interest expense paid by Mrs. L over the amount of the dividends received by her which were attributed back to him.

74.5(11) ITA was not applicable. 74.5(11) ITA was not applicable.

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0OVERS v. LIPSON: THE DECISIONS

THE DECISION IN OVERS:

• The Court allegedly based its decision on the principles enunciated by the Supreme Court in the Canada Trustco case.

• It first reviewed the definition of an “avoidance transaction” under 245 ITA and affirmed that where a transaction or a series of transactions would result in a tax benefit, it was a question of fact whether a specific transaction constituted a transaction established for bona fide purposes other than to obtain a tax benefit.

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0OVERS v. LIPSON: THE DECISIONS

THE DECISION IN OVERS (Cont’d):

• The Court then thoroughly examined each specific transaction within the terms of 15(2), 73(1) and 74.1(1) ITA and concluded that none of them constituted an avoidance transaction because they followed the rules literally outlined within each such provision and each had bona fide purposes (borrowings, repayment of debt and transfer between spouses).

• Finally, the Court took the position that even if the transactions were to be considered as “avoidance transactions”, GAAR would not be applicable because the purposes of the relevant provisions of the Act were not frustrated or defeated.

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0OVERS v. LIPSON: THE DECISIONS (Cont’d)

THE DECISION IN LIPSON:

• The Court made an analysis of 20(1)(c), 20(3), 73(1) and 74.1(1) ITA in order to determine the legislator’s intent in enacting the provisions. Fundamentally however, the Court considered without analysis that the “scheme” was abusive.

• It found that interest deductions are provided to encourage the accumulation of capital with the potential to produce income and that the spousal rollover rules are to facilitate inter-spousal transfers without immediate tax consequences.

• Since it was admitted that there was an avoidance transaction, the Court only had to conclude that the transactions constituted an abuse or misuse of the ITA (would it have mattered if this admission hadn’t been made?).

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0OVERS v. LIPSON: THE DECISIONS (Cont’d)

THE DECISION IN LIPSON (Cont’d):

• The Court concluded that the series of transactions preceding the acquisition of Mr. L and Mrs. L’s personal house was a misuse and abuse of the ITA, more specifically of 20(1)(c) and 20(3) ITA. Furthermore, it asserted that 73 and 74.1 ITA were inappropriately used to achieve this purpose.

• The Court noted the fact that there was no proof of payment by Mrs. L of the interest pertaining to the loans, but concluded that it was irrelevant since the transactions were abusive.

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0GAAR: THE CURRENT SUPREME COURT OF

CANADA’S APPROACH

• GAAR was examined and analyzed for the first time by the Supreme Court in Canada Trustco and Matthew.

• To fully understand Overs and Lipson, the principles enunciated by the Supreme Court in Canada Trustco and Matthew must be examined.

• A thorough set of guidelines was outlined in Canada Trustco.

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0THE CANADA TRUSTCO DECISION

THE FACTS:

• Canada Trustco Mortgage Co. (Canada Trustco) was carrying on a business as a mortgage lender.

• Canada Trustco purchased a number of trailers, which were then leased back to the vendor.

• Canada Trustco claimed capital cost allowance (CCA) on the trailers.

• The Minister reassessed Canada Trustco under GAAR, on the basis that it was never the owner of the trailers.

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0THE CANADA TRUSTCO DECISION (Cont’d)

THE DECISION:

• The Court enunciated that GAAR encompasses three requirements:

1. A tax benefit resulting from a transaction or part of a series of transactions;

2. An avoidance transaction, i.e. a transaction that cannot be said to have been reasonably undertaken or arranged primarily for bona fide purpose other than to obtain a tax benefit; and

3. An abusive avoidance transaction, i.e. a transaction of which it cannot be reasonably concluded that the conferred tax benefit would be consistent with the object, spirit or purpose of the provisions of the ITA upon which it is relying.

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THE DECISION:

• A tax benefit

– A reduction, avoidance or deferral of tax or an increase in a refund of tax or other amount.

– The existence of a tax benefit is a question of fact.

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THE DECISION:

• An avoidance transaction

– The intrinsic test in the “avoidance transaction” must be interpreted broadly because GAAR was not enacted to introduce uncertainty in tax planning.

– “Non-tax purposes” is not the equivalent of “business purposes”. The former expression has a broader meaning.

– If only one transaction in a series is an “avoidance transaction”, a tax benefit may be denied under GAAR. Conversely, if each transaction of a series is carried for bona fide purposes, GAAR cannot be applied.

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THE DECISION:

• A misuse or abuse of the Act

– The “misuse or abuse” requirement is one test but it entails a two-part analysis:

1. An interpretation of the text and context of the provisions giving rise to the tax benefit to determine their purposes.

2. A determination of whether the avoidance transaction or series of transactions frustrated or violated the legislator’s intent in enacting the provisions giving rise to the tax benefit.

– The first part of the analysis is a question of law and the second one a question fact.

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THE DECISION:

– The burden of proof with respect to this requirement relies on the Minister. The benefit of the doubt goes to the taxpayer.

– An abusive tax avoidance transaction usually (1) lacks a proper basis relative to the object, spirit or purpose of the provisions or (2) is dissimilar to the transactions that are contemplated by those provisions.

– GAAR was enacted as a provision of last resort to address abusive tax avoidance, not to introduce uncertainty in tax planning.

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0A COMPREHENSIVE DISCUSSION OF OVERS

Does Overs accurately follow Canada Trustco’s analysis and is its rationale debatable?

1. Tax benefit

– The Court concludes that the Mr. O has obtained a tax benefit. This is a justified conclusion. Mr. O obtained a deduction for interest he did not pay and was purportedly for a non-eligible use.

– The Court finds that the transaction or the series of transactions results in a tax benefit.

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0A COMPREHENSIVE DISCUSSION OF OVERS (Cont’d)

2. Avoidance transaction

– The Court analyses each transaction to determine whether any were motivated primarily by bona fide purposes.

– What was the transaction or what were the transactions forming the series that resulted in a tax benefit?

– There was a borrowing, a transfer of property by way of sale, a loan repayment and then payments of interest on the loan.

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– Were there bona fide motives for each of the transactions? The loan was incurred to allow Mrs. O to acquire shares in Oco. Mrs. O acquired shares in Oco from Mr. O and became the legal and beneficial owner of such shares thereby being entitled to all the risks and rewards associated with such ownership. Mr. O owed money; he divested himself of assets to raise the requisite funds and used such funds to repay a legal obligation. Mrs. O paid interest on the loan incurred to acquire an income producing asset. The Court found that each of these transactions was motivated primarily for bona fide purposes other than to obtain a tax benefit.

– Therefore there was no reason to go further.

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– Is the test of determining whether there is an avoidance transaction a test that looks at the overall result to determine whether there were bona fide purposes or is the test a transaction-by-transaction test?

– In Overs, the test was held to be a transaction-by-transaction test. Therefore, the “scheme” of transferring assets within a family unit on a tax-deferred basis and creating tax-deductible interest that was attributed back to Mr. O had to be ignored. If however, any of the transactions were not for bona fide purposes, then the overall scheme would be reviewed to determine whether there was a misuse or abuse of the provisions of the ITA.

– Notwithstanding the Court’s findings that there were no avoidance transactions, the Court did go further, albeit as an obiter.

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3. Abusive tax avoidance

– The Court asserts, in a vague obiter dictum, that if the transactions were “avoidance transactions”, they would not be abusive.

– In light of the principles enunciated in Canada Trustco, the Court’s approach is faulty:

a) There is no endeavour to find out the purposes of either 20(1)(c), 73, 74.1 ITA or any other provision relied upon or avoided (in our view 74.5(11) ITA).

b) There is no endeavour to determine whether the series of transactions giving rise to the deduction of interest to Mr. O frustrated or violated the legislator’s intent with respect to those provisions.

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– The Court should have examined whether the Overs’ arrangements gave rise to a deduction of interest with respect to an ineligible debt (incurred indirectly to reimburse a personal loan).

– Did the arrangements frustrate or violate the purposes of 20(1)(c) ITA? To answer this properly, had Mrs. O deducted the interest, would the arrangements have frustrated or violated the purposes of 20(1)(c) ITA? Probably not.

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– Did the arrangements frustrate or violate the purposes of 74.1(1) ITA? One would think probably. Mr. O obtained a tax deduction even though he did not pay interest nor borrow to acquire an income producing property. Had there been income instead of losses, would the arrangements have frustrated or violates the purposes of 74.1(1) ITA? Probably not since through the combination of 74.1(1) and 74.5(11) ITA, where there is an attempt to inappropriately deflect income from one spouse to another, the income will be attributed back. The legislators felt the need to also deflect losses under 74.1(1) ITA but did not determine that there was such need in 74.5(11) ITA. How then could the arrangements have frustrated or violated the provisions of 74.1(1) ITA when they operated exactly as they were meant to operate? This could not be a misuse or abuse of the provisions relied upon.

– Should the Court or the Minister have argued that the provisions of 74.5(11) ITA were frustrated or violated? This provision is an anti-avoidance of an avoidance provision in an of itself. How can it be misused or abused? Does the Court have the power to invoke legislative change by adding the concept of a loss to 74.5(11) ITA or is that what GAAR is intended to do? We believe that Canada Trustco does not give the Courts that power.

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0A COMPREHENSIVE DISCUSSION OF LIPSON

In Lipson, the Court seems to present better, more thorough reasoning. However, the judgment contains several inconsistencies.

1. Tax benefit

– The Court concludes that Mr. L had obtained a tax benefit, as admitted by the parties. This finding and admission are justified.

2. Avoidance transaction

– The Court concludes that the transactions were avoidance transactions, also admitted by the parties. This finding was justified based upon the admission, but was the admission justified?

– The Court identified the series of transactions as an abusive “scheme” even before analyzing the transactions. This may have been justified as a consequence of the admission that there was an avoidance transaction.

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0A COMPREHENSIVE DISCUSSION OF LIPSON (Cont’d)

– Had the parties not agreed on this point, would the Court have been forced into an interpretation similar to that given in Overs, whereby the scheme had to be ignored in determining whether there was an avoidance transaction, but instead each transaction in and of itself had to be analyzed to determine whether it was an avoidance transaction?

– The result of a transaction is only relevant in determining whether there was a tax benefit. It is not relevant in determining whether there was an avoidance transaction.

– As offensive as the Court in Lipson found the scheme, could it have found an avoidance transaction within the series of transactions? In this case, probably, since the plan does not appear to be well followed. It was unlikely that Mrs. L paid the interest expense which would lead us to conclude that she never intended nor was capable of acquiring the shares for any purpose other than to obtain a tax benefit.

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– In the Court’s opinion, all the transactions in the series specifically constituted an abuse and misuse of 20(1)(c) and 20(3) ITA and the other provisions 73(1) and 74.1(1) ITA were similarly misused.

– The Court’s approach is not completely accurate. J. Bowman asserts that 20(3) ITA is at the “heart of the scheme”. However, if the initial loan had been made for an eligible use, the refinancing thereof by placing a mortgage on the personal house could not have been a misuse or abuse.

– If interest deductibility is the misuse or abuse, the core of the abuse and misuse in the series of transactions must be inherent to 20(1)(c) ITA and the initial loan not the refinancing thereof.

– It can be argued that it is not the interest deductibility here that is abusive. It is the interest deductibility by Mr. L that is abusive in the eyes of J. Bowman. However, as J. Bowman found (and was overturned) in Singleton v. The Queen, the economic purpose of the series was to generate tax-deductible interest in respect of a borrowing for non-income producing purposes and Lipson even went further than Singleton by having someone else deduct the interest.

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– The reasoning seems to rely to a great extent on the absence of a so-called economic or business purpose test, which relates more to the avoidance test.

– In fact, J. Bowman distinguishes Overs pre-texting that there was an underpinning of commercial planning in that case.

– Yet the analysis in Overs does not take into consideration, at any point, the economic or business substance underlying the taxpayers’ arrangements.

– One can possibly deduce that in Overs, Mrs. O was capable of paying the interest and the intention was to transfer assets to her for her own benefit. In Lipson, J. Bowman did not see any redeeming qualities from the scheme to allow him to determine that there was any merit to a business or economic purpose.

– With respect, Canadian tax law does not combine spouses as a unit for tax purposes. Therefore, even if economic purpose is justifiable as a determination for a finding of GAAR, it cannot cross over between spouses. Mrs. L borrowed to acquire shares, period. Attribution granted Mr. L the interest deduction, not the borrowings.

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0WHAT ABOUT SINGLETON?

One cannot help but wonder about the effect of Overs, Lipson and even Canada Trustco on the Supreme Court decision of Singleton.

THE FACTS– On October 27, 1988, Mr. S (a partner in a law firm) withdrew an amount of $300,000 from the

capital account of his partnership to buy a house for personal purposes.

– Mr. S then borrowed an amount of $300,000 (secured by his house) and deposited it in his capital account

THE DECISION:– The taxpayer clearly used the borrowed funds to refinance his capital account.

– There was a direct link between the borrowed money and an eligible use: the refinancing of partnership capital for the purposes of earning income.

– The deduction was allowed under 20(1)(c) ITA.

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Does Overs or Lipson contradict Singleton?

– Singleton was rendered before GAAR was enacted.

– The rationale requiring the existence of the “direct use” of the borrowed funds for eligible purposes is of no use in the context of GAAR analysis.

– The judgment just sets the guidelines in determining whether a deduction of interest is allowed within the literal interpretation of the law.

– In a non-GAAR context, Singleton held for the principle that there is no economic purpose in Canadian tax law. This doesn’t mean that this concept doesn’t exist in determining whether there is an avoidance transaction or an abusive avoidance transaction in connection with determining whether GAAR should be applicable.

– Unfortunately, Singleton cannot be relied upon in a GAAR context.

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Would GAAR apply to Singleton today?

– Maybe; but, GAAR requires:

1. A tax benefit: A tax benefit was conferred on Mr. S through interest deductibility under 20(1)(c) ITA.

2. An avoidance transaction: The transactions may not have been entered into primary for non-tax purposes. Why was the capital returned to Mr. S just to have it reinvested after a borrowing. Where is the non-tax purpose?

3. An abusive avoidance transaction: Mr. S accessed his accumulated tax paid capital to buy a house. He then incurred debt to finance his recapitalization of his capital account. If economic purpose does in fact find its way into GAAR determination, then one could see that nothing changed except that there was a new house and a new loan. It would be hard to convincingly argue that this economic purpose concept should be seen in isolation. The partnership could have borrowed to return its capital for all partners and the partnership would have deducted the interest. Why should a slightly different fact pattern (borrowing outside of the partnership to replenish the capital) result in GAAR?

Documents

THE CURRENT STATE OF GAAR: WHAT TO ANTICIPATE AFTER OVERS AND LIPSON? Jerry Wise, CA