Tax practitioners are split on two long-awaited Supreme Court of Canada decisions that introduced a three-part legal test for applying the Income Tax Act’s “general anti-avoidance rule.”

The ruling states an avoidance transaction will be ruled abusive if it contravenes the “object, spirit and purpose [of the Income Tax Act provisions] utilized in a taxpayer’s tax planning.”

The troubling provision — also known as the “GAAR” — has been used by the Canada Revenue Agency since 1987 as a broad statutory tool to combat whatever it perceives to be aggressive tax avoidance.

Until now, the rule has been vague, enabling the CRA to crack down on transactions that “would result directly or indirectly in a misuse [or] abuse” of provisions of the act.

Some tax practitioners are welcoming the Oct. 19 SCC rulings in Mathew v. Canada and The Queen v. Canada Trustco, saying the highest court in the land has finally restored common sense to the way the CRA conducts enforcement.

The SCC has brought back the “old smell test,” says Robin MacKnight, a veteran tax lawyer with Wilson Vukelich LLP in Markham, Ont. “If a transaction smells bad, it probably is. This is going to stop people from pushing the envelope.”

However, other tax practitioners say the SCC has set out a legal test for the application of the GAAR that is vague and will encourage the CRA to incite more tax litigation with taxpayers.

This aspect will make it harder for tax advisors to give guidance to their clients, says Tom Bauer, a Toronto-based partner with the national tax law firm Thorsteinssons LLP. The purposive approach is “nice language,” says Bauer, but at the end of the day it will give tax judges greater latitude to rule against taxpayers simply because they don’t like their tax-planning deals.

The SCC denied the appeals in both the GAAR cases, resulting in a victory for the taxpayer in the Canada Trustco case, which involved claiming a depreciation deduction for a complex lease-buyback operation, and a loss for the investors in the Mathew case, which involved the rules limiting loss-sharing with arm’s-length parties.

For financial advisors, the facts of these two cases are not as important as the new three-part legal test that the SCC set out for applying the GAAR.

First, there must be a tax benefit, which is a reduction, deferral or avoidance of taxes. Whether such a benefit exists as a result of a transaction will be shown by the facts of each case. The size of the tax benefit will not be relevant. It will be up to the taxpayer to establish that there is no benefit.

Second, the transaction must be an avoidance transaction. There may be a series of transactions involved in the tax dispute. At least one of them must have been undertaken to result in a tax benefit.

Third, the avoidance transaction must be abusive. It should be noted that it has been a long-held legal principle, enunciated by the SCC, that taxpayers are permitted to arrange their tax affairs to minimize their tax liability. This differs from abusive tax avoidance or criminal tax evasion.

In determining whether a transaction is abusive, the SCC says, the courts should not look to an overriding tax policy that is not anchored in the specific provisions of the Income Tax Act. In stating this, the SCC overruled the Federal Court of Appeal, which said in an earlier decision that a separate misuse and abuse analysis based on a tax policy can be used to determine application of the GAAR.

Instead, the “object, spirit and purpose” of the allegedly abused or misused provisions of the act must be established as part of determining whether the GAAR should be applied. Further, the SCC says, the abuse must be clear, and resolved in the taxpayer’s favour.

Finally, it will be up to the CRA and its Department of Justice counsel to prove that abuse or misuse has occurred.

The SCC acknowledges that the test it set out is not what is known in legal circles as a “bright-line” test. It does not provide absolute guidance to taxpayers — or advisors.
Despite this, the SCC urges that the Income Tax Act, in general, and the GAAR, in
particular, be interpreted to provide consistency, predictability and fairness for taxpayers.

@page_break@“This is restoring a lot of common sense to the tax world. If you’re doing tax planning and you have to stretch a provision to make the planning work, then it’s probably going to attract GAAR,” says MacKnight.

He adds that the GAAR was originally used as “a big, black club. The CRA would wave it and taxpayers would run away,” he notes. Now, the CRA will have to prove that the transaction is abusive.

“The SCC has finally laid down the law. The onus is on the government, as opposed to the taxpayer, to establish that a transaction is abusive,” explains Jamie Golombek, vice president of taxation and estate planning for AIM Funds Management Inc. in Toronto.

As a basic example, the SCC says, an RRSP contribution is a tax benefit but it wouldn’t get to Step 2 in the GAAR analysis because it could not be viewed as an avoidance transaction. The provisions enabling RRSP contributions and tax deferral are based on government policy to encourage taxpayers to save for their retirement.

On the other hand, donation schemes that involve claiming a tax credit for an amount that greatly exceeds the amount actually donated — due to the machinations of the underlying tax shelter scheme — are more likely to attract the GAAR.

Robert McMechan, an Ottawa-based tax litigator and co-author of Thomson Carswell’s Tax Court Practice, has a slightly different take on how the SCC decisions have provided certainty to the tax system. He says the tax landscape has shifted in more ways than one.

The SCC’s GAAR decisions are a departure from years of pronouncements from the court that government lawyers could not attack taxpayers’ tax-planning if it fell within the “plain meaning” of tax act provisions, says McMechan. As a result, taxpayers have won a long string of GAAR cases brought against them.

That will now change, he says. “At the end of the day [a taxpayer] can’t be satisfied simply with the fact that what [he] is doing meets the technical meaning of the act. It must be seen to accord with the purpose of the provisions.”

This shift will make it easier for the CRA to come after taxpayers, says Thorsteinssons’ Bauer. Using the SCC’s “purposive approach,” there will be more instances of transactions that the CRA finds offensive, he suggests.

But the purposive approach to legislative interpretation is “esoteric,” he says. This means that GAAR cases will still have to be heard on a “case-by-case basis. It will create more uncertainty and result in more litigation.”

If so, that will translate into more litigation costs for
taxpayers. IE