Friday, 1 June 2012

Canada Trustco GAAR Analysis in McClarty

The following was published in the May edition of the Canadian Tax Highlights which is published by the Canadian Tax Foundation.  It is republished with permission.  Note to reader - the following article discusses  a recent case which considered whether the income splitting between a father and three minors represented abusive tax avoidance.  Around 1988 the Canadian Parliament introduced  section 245 to the Income Tax Act.  Section 245 contains the general anti-avoidance rule better known as GAAR.  Essentially Canada Revenue Agency ("CRA") may use GAAR to attack any planning which the CRA deems to be abusive.  The tax benefit need not be great - the existence of a tax benefit is sufficient to invoke GAAR by the CRA.  It is up to CRA to prove that GAAR applies. Case law has established that GAAR does not apply where the transaction was undertaken by the taxpayer for bona fide purposes other than obtaining the tax benefit.  As such if the taxpayer can show that the taxpayer undertook the transaction primarily for reasons (e.g. commercial, philanthropic, family etc.)  other than to gain a tax benefit - GAAR should not apply.  The article is as follows:

On March 21, 2012, the TCC released its judgment in McClarty Family Trust (2012 TCC 80) on whether GAAR applied to what the CRA claimed was income splitting between a father and three minors for the 2003 and 2004 taxation years. The CRA sought to recharacterize as dividends the capital gains distributed from the McClarty family trust (MFT) to its minor beneficiaries. Although 2011 amendments to section 120.4 (new subsections 120.4(4) and 120.4(5)) render its planning obsolete, McClarty followed the SCC analysis in Canada Trustco (2005 SCC 54), which the SCC did not reject in Copthorne Holdings Ltd. (2011 SCC 63). McClarty's GAAR analysis thus continues to be relevant for tax practitioners.

The father of the minor beneficiaries, Mr. M, was a professional engineer specializing in geotechnical engineering. He was employed by Clifton Associates in its information technology division, Envista, where he designed and marketed Envista software. In 2001 his bid to purchase the Envista division from Clifton was turned down, and he resigned. Clifton unsuccessfully sought to retain Mr. M and even threatened him with a draft statement of claim. Mr. M and three other Clifton employees started a new company, Projectline Solutions Inc., which became a successful competitor of Clifton. Clifton threatened Projectline with lawsuits.

Mr. M sought to creditor-proof his holdings in Projectline against a potential lawsuit by Clifton. Following professional advice, he proceeded to transfer his shares in Projectline to a holdco, MPSI. A trust, MFT, was settled by Mr. M's father; Mr. M and his wife were trustees and also trust beneficiaries (together with their three minor children). A numbered company (101SK) was incorporated to capture future investments and facilitate the creditor protection scheme; Mr. M was its sole shareholder and director.

In 2003 and in 2004, MPSI declared a stock dividend on its class B common shares, which were held by MFT. The stock dividend consisted of 48,000 class E non-voting MPSI preferred shares; each share's PUC, ACB, and redemption price was $1. MFT then sold the stock dividend shares (class E) to Mr. M on the same day for $48,000 payable by a promissory note that carried interest at 0 percent (10 percent after payment was demanded). The transaction yielded a capital gain of $47,999 for MFT, which distributed the gain equally to its three minor beneficiaries (a taxable capital gain of $7,999 each); the amounts were paid by the issuance to each of a promissory note with the same interest terms as the note given to MFT by Mr. M.

On that same day, Mr. M repaid loans and advances of $48,000 to MPSI, which then paid $48,000 as a shareholder loan to MFT, which in turn made a loan to Mr. M (referred to as a trustee loan). Mr. M then repaid a second sum of $48,000 to MPSI for other shareholder loans.

At year-end, Mr. M sold the class E shares to 101SK for a $48,000 promissory note without interest. On the same day, MPSI redeemed for $1 each the stock dividend (class E) shares (a total redemption price of $48,000). The deemed dividend received by 101SK on the redemption did not trigger tax because it was deemed paid by a taxable Canadian corporation.

The TCC turned to the guidance in Canada Trustco, which summarized the approach to GAAR. Three requirements must be established to permit GAAR's application: (1) a tax benefit must result from a transaction or part of a series of transactions (subsections 245(1) and (2)); (2) the transaction must be an avoidance transaction--it cannot be said to have been reasonably undertaken or arranged primarily for a bona fide purpose other than to obtain a tax benefit; and (3) there must be abusive tax avoidance--it cannot be reasonably concluded that the tax benefit was consistent with the object, spirit, or purpose of the provisions relied on by the taxpayer. The burden is on the taxpayer to refute the existence of the tax benefit and the avoidance transaction, and the burden is on the minister to establish the abusive tax avoidance. (In McClarty, only the first two requirements were addressed; in Copthorne, the appellants conceded the first two requirements and the third requirement was at issue.)

In McClarty, the appellants conceded only the first requirement--that there was a tax benefit as a result of a series of transactions. The appellants contested the minister's conclusion that the transactions were avoidance transactions and argued that they were undertaken for a bona fide purpose other than to obtain a tax benefit. The TCC agreed, following the SCC's guidance in Canada Trustco for determining whether there was a bona fide purpose for the transaction:

[T]his is a factual inquiry. The taxpayer cannot avoid the application of the GAAR by merely stating that the transaction was undertaken or arranged primarily for a non-tax purpose. The Tax Court judge must weigh the evidence to determine whether it is reasonable to conclude that the transaction was not undertaken or arranged primarily for a non-tax purpose. The determination invokes reasonableness, suggesting that the possibility of different interpretations of the events must be objectively considered.

The SCC also said that there should be "an objective assessment of the relative importance of the driving forces of the transaction." The TCC in McClarty cited Rothstein J's statement in OSFC Holdings Ltd. (2001 FCA 260) to the effect that the assessment should be done at the time the transaction was undertaken, not at a later time with the benefit of hindsight.

After considering the facts that existed when the transactions were structured, the TCC concluded that Mr. M was very much concerned with Clifton's actions and feared the loss of his personal assets in a lawsuit. He had already been threatened with a draft statement of claim; Clifton continually threatened to sue and had sent letters to the Canadian International Development Agency and to the Comision Interinstitucional de la Cuenca Hidrografica del Canal de Panama warning that Mr. M and others were falsely holding themselves out as the representatives of Clifton's Envista software. The TCC concluded that Mr. M felt threatened by Clifton, and that that threat was a bona fide reason for the transactions' structure: Mr. M wanted to remove his personal assets from Clifton's reach, a reason consistent with a creditor-proofing strategy. After all, "McClarty's assets in MPSI were partially reduced for the benefit of MFT and, once redeemed, the assets would be entirely out of the hands of MPSI and Darrell McClarty."

The TCC rejected the CRA's argument that the structuring was an avoidance transaction because creditor proofing could have been achieved by having MPSI pay a dividend to MFT, allocating the income to the minor beneficiaries by way of a promissory note, and loaning the funds to Mr. M. The TCC said that even if the suggested alternative structure would have achieved creditor proofing, it would have been less effective because of the higher tax rate on dividends allocated to the minor beneficiaries. The court also rejected an analysis that would splinter off the sale of shares by MFT to Mr. M and the subsequent sale to 101SK to reduce the tax consequences of the creditor proofing; those transactions would not have occurred in the absence of the need to protect MPSI's assets.

The TCC noted that the spirit of the holding in Duke of Westminster was mentioned in the explanatory notes to subsection 245(3), which said that tax planning with the objective of attracting the least possible tax is a legitimate and accepted part of Canadian tax law. The TCC quoted the SCC in Canada Trustco, where it in turn quoted Finance's explanatory notes:
Subsection 245(3) does not permit the "recharacterization" of a transaction for the purposes of determining whether or not it is an avoidance transaction. In other words, it does not permit a transaction to be considered an avoidance transaction because some alternative transaction that might have achieved an equivalent result would have resulted in higher taxes.
The TCC in McClarty concluded as follows:

The [SCC] has made it clear in many decisions that, absent a specific provision to the contrary, it is not the Court's role to prevent taxpayers from relying on the sophisticated structure of their transactions, arranged in such a way that the requirements of the particular provisions of the ITA are met, on the basis that to allow it would be inequitable for those taxpayers who have chosen not to structure their transactions that way (Shell Canada Ltd. v. R ., [1999] 4 C.T.C. 313; Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536; Singleton v. R ., [2002] 1 C.T.C. 121).

Sunita Doobay
TaxChambers, Toronto

Canadian Tax HighlightsVolume 20, Number 5, May 2012
©2012, Canadian Tax Foundation

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