In a unanimous decision, released on December 16, 2011, the Supreme Court of Canada ruled in Copthorne Holdings Ltd. v Canada,1 that the general anti-avoidance rule (GAAR) applied to deny the taxpayer the benefits arising from a paid-up capital (PUC) preservation transaction. Copthorne is the fourth GAAR case heard by the Supreme Court.2 While the decision, delivered by Justice Rothstein, follows the approach to GAAR established in its prior decisions, particularly Canada Trustco (see our Osler Update dated October 27, 2005), the decision will be scrutinized for further insight into the approach of the Supreme Court to the application of GAAR.
At issue in Copthorne was the redemption for $142 million of shares of a Canadian corporation wholly owned by a non-resident. The redemption of shares held by the non-resident would give rise to a deemed dividend subject to Canadian withholding tax, to the extent the redemption price exceeded the PUC of the shares redeemed. The Canadian corporation arose from the amalgamation of two predecessor corporations which were originally parent and wholly-owned subsidiary. $96 million had been paid-in as share capital of the parent and, of that, $67 million was invested in and formed the PUC of the shares of the subsidiary. Prior to the amalgamation the shares of the subsidiary had been transferred to make the corporations sisters and their amalgamation a “horizontal” rather than “vertical” amalgamation.
Under the governing corporate law and subsection 87(3) of the Income Tax Act (the Act), the stated capital and PUC, respectively, of the shares of the former subsidiary, which would have been cancelled upon a vertical amalgamation, were preserved upon the resulting horizontal amalgamation. Subject to GAAR, upon the horizontal amalgamation the PUC of the shares of the parent and former subsidiary would be aggregated and no deemed dividend would arise on redemption of shares for $142 million, enabling a tax-free return of capital in excess of the $96 million original investment.
The Canada Revenue Agency reassessed the taxpayer for failure to withhold tax on the share redemption, invoking GAAR to deny the increase in PUC in respect of the shares of the former subsidiary otherwise resulting from the horizontal amalgamation. Both the Tax Court3 and Federal Court of Appeal4 upheld the reassessment.
The Supreme Court adopted in Canada Trustco a unified “textual, contextual and purposive” approach to all questions of interpretation of the Act. In Copthorne, Justice Rothstein expressly distinguishes the application of this approach in the context of a technical interpretation of the Act and under GAAR. In the former case, a textual, contextual and purposive approach is applied in order to interpret the text of specific provisions of the Act. It appears that only when an avoidance transaction gives rise to a tax benefit is a textual, contextual and purposive interpretation to be applied to search for the rationale that underlies the words that may not be captured by the bare meaning of the words themselves. These comments are likely to form part of the ongoing tension as to the relative importance of text, context and purpose in interpreting provisions of the Act where GAAR is not invoked.
There are three requirements for GAAR to apply: “tax benefit”, “avoidance transaction” and misuse or abuse of the Act. While the Supreme Court has addressed each of these requirements, in each of the three GAAR cases to reach the Court before Copthorne, the taxpayer conceded the presence of both a tax benefit and an avoidance transaction. Copthorne is the first case in which all three requirements were put in issue before the Court.
The Supreme Court upheld the finding of the Tax Court that the presence of a tax benefit was established by comparison to the vertical amalgamation which would have been undertaken but for the resulting cancellation of PUC of the shares of the subsidiary.
Avoidance Transaction and “Series”
The Crown alleged that the tax benefit arose from a series of transactions. The parties agreed that the transactions resulting in the horizontal amalgamation formed a series of transactions under the “common law” test. However, the parties disagreed as to whether the statutory expansion of the common law test under subsection 248(10) to include transactions completed in contemplation of a series of transactions, included in the series the subsequent redemption of shares. The taxpayer argued that the passage of a year’s time and the intervening introduction of tax amendments which prompted the redemption of shares held by the non-resident precluded the redemption from forming part of the preceding series of transactions which included the horizontal amalgamation. One of the primary bases for the taxpayer’s application to the Supreme Court for leave to appeal was that the lower court decisions reflected confusion over the proper application of the subsection 248(10) “series” test laid down by the Supreme Court in Canada Trustco.
The Copthorne decision reiterates the Canada Trustco test for the “in contemplation of” requirement in essentially the same words. The Court rejects the necessity of a “strong nexus” between transactions or series offered by the Tax Court in Copthorne, endorses the insufficiency of a “mere possibility” or “extreme degree of remoteness” from MIL (Investments) S.A.,5 does not refer to the “motivating factor” test suggested by the Federal Court of Appeal in Copthorne, and clarifies that the “in relation to” or “because of” tests from Canada Trustco are the tests and not an expansion of “in contemplation of”.
The Court expressly revisited and confirmed that “in contemplation of” may be applied retrospectively in respect of a preceding series of transactions as well as prospectively in respect of a subsequent series. The Court noted that length of time between transactions and intervening events may be relevant considerations in some cases.
The decision in Copthorne leaves ample room for ongoing uncertainty and debate as to the relationship necessary to include a transaction in a preceding or subsequent series of transactions. The Court notes that the context of subsection 248(10) provides an indication against a narrow interpretation of a “series” of transactions.
Misuse or Abuse
The Tax Court found the double-counting of PUC by undertaking a horizontal rather than a vertical amalgamation to be abusive and applied GAAR. The Federal Court of Appeal applied GAAR to deny what that Court appeared to view as a misuse or abuse of the Alberta Business Corporations Act. The Supreme Court upholds the application of GAAR; however, Justice Rothstein is very careful to tie the scheme of the PUC regime and purpose of the provisions to the specific wording of subsection 87(3) and particularly the parenthetical exclusion in respect of capital of subsidiary shares upon vertical amalgamations.
The difference in how the misuse or abuse analysis is expressed by the Supreme Court and the lower courts in Copthorne emphasizes the approach following Canada Trustco. While GAAR is a provision of last resort applicable only where transactions “work” under the technical rules of the Act, a misuse or abuse supporting the application of GAAR cannot be based only upon broad statements of tax policy, such as a general policy against surplus stripping or even against double-counting of PUC, but must ultimately be derived from the wording of the sections of the Act alleged to have been abused. Justice Rothstein expressly considers and rejects the argument that subsection 87(3) is simply adopting the corporate law’s approach to stated capital and finds in the text and context of subsection 87(3) specific intention to limit the preservation of PUC upon amalgamation to the aggregate tax-paid investment in shares of the amalgamating corporations. On this basis, Justice Rothstein finds the series of transactions, but for GAAR, would frustrate and defeat the purpose of subsection 87(3), circumvent the parenthetical limitation on PUC in subsection 87(3) and achieve a result subsection 87(3) was intended to prevent and thus defeat its underlying rationale.
Victory in Copthorne may embolden the Crown. The Supreme Court has confirmed the breadth of the “series of transactions” test under GAAR and other provisions of the Act (which are not expressly limited to a common law series) and accepted a degree of uncertainty in the potential application of GAAR to redetermine common tax attributes (in obiter, including arm’s length transactions). However, Justice Rothstein, speaking for the Court, makes clear that a finding of misuse or abuse of the Act supporting the application of GAAR must be grounded in a unified textual, contextual and purposive interpretation of the provisions of the Act alleged to have been abused. The Supreme Court’s decision in Copthorne reaffirms the onus on the Minister to demonstrate clearly an alleged abuse and that the benefit of doubt is given to the taxpayer.
If you have any questions or require additional analysis of the potential application of GAAR, please contact any member of our National Tax Department.
1 2011 SCC 63 (Copthorne)
2 Following Canada Trustco Mortgage Corporation v Canada (Canada Trustco), 2005 DTC 5523, Mathew v Canada, 2005 DTC 5538 and Lipson v Canada, 2009 DTC 5015 (see our Osler Update).
3 2007 DTC 1230
4 2009 DTC 5101
5 2006 DTC 3307 (TCC), aff’d 2007 DTC 5437 (FCA)