Supreme Court of Canada Clarifies Application of the General Anti-Avoidance Rule to Tax Treaty Exemption

written on behalf of Feigenbaum Law

The Supreme Court of Canada recently released a decision in which it had to determine whether the general anti-avoidance rule under Canadian tax legislation could be applied to a company that had claimed a tax exemption under a tax treaty with Luxembourg.

American Company Incorporates Subsidiaries in Canada and Luxembourg

In 2011, two American firms founded an American company for the purpose of acquiring and developing unconventional oil and natural gas properties. The company incorporated a wholly-owned Canadian subsidiary to carry on its business called Alta Canada.

In 2012, Alta Canada underwent a restructuring, which involved the incorporation of Alta Luxembourg under the laws of Luxembourg. Alta Luxembourg’s shares were issued to a new Canadian partnership and it simultaneously purchased all of Alta Canada’s shares.

Luxembourg Subsidiary Claims Tax Exemption for $380 Million in Share Sale

In 2013, Alta Luxembourg sold its shares in Alta Canada, resulting in a capital gain in excess of $380 million.

The capital gain was reported to the Luxembourg tax authorities.

However, in its Canadian tax return for 2013, Alta Luxembourg claimed an exemption from Canadian tax on the basis that the gain was not included in its “taxable income earned in Canada” under s. 115(1)(b) of the Income Tax Actbecause the shares were “treaty-protected property” under a tax treaty between Canada and Luxembourg’s governments. It claimed that, as a Luxembourg resident, the treaty exempted it from paying Canadian taxes arising from a capital gain on the alienation of shares the value of which is derived principally from immovable property situated in Canada and in which the business of the company was carried on.

Canada Denies Tax Exemption Claim, But Tax Court Allows ForExemption

Canada’s Minister of National Revenue (“Minister”) denied the treaty exemption.

Alta Luxembourg then appealed the Minister’s decision to the Tax Court of Canada. At trial, the Minister argued that the business property exemption in the Treaty did not apply. In the alternative, if the shares did qualify as treaty-protected property, the Minister argued that the general anti-avoidance rule (“GAAR”) in s. 245 of the Income Tax Act should apply.

The Tax Court found in favour of Alta Luxembourg, ruling that the shares were treaty-protected property. With respect to the GAAR, the parties agreed that the restructuring was an “avoidance transaction” as defined in theIncome Tax Act, that resulted in a tax benefit. However, the Tax Court held that the avoidance transaction did not result in a misuse or abuse of the provisions of theIncome Tax Actor the Treaty.

On appeal, the Minister did not dispute the Tax Court’s finding that Alta Luxembourg had satisfied the requirements for the business property exemption. Thus the only issue was whether the GAAR applied. The Federal Court of Appeal found that it did not and dismissed the Minister’s appeal.

The Minister appealed to the Supreme Court of Canada.

In its submissions to the Supreme Court, the Minister conceded that Alta Luxembourg was a resident of Luxembourg for the purposes of the Treaty and that a business had been carried on in an immovable property. For its part, Alta Luxembourg admitted the existence of a tax benefit and an avoidance transaction. Therefore, the only element in dispute was the abusive nature of the transaction, which raised the following issues:

1)   What are the object, spirit, and purpose of the relevant provisions of the Treaty? and

2)   Had the courts below erred in concluding that the avoidance transaction had not resulted in an abuse of the Treaty provisions?

Supreme Court of Canada Addresses the GAAR and Abusive Tax Avoidance Principles

The court began by explaining that the GAAR applies both to the abuse of provisions found in theIncome Tax Act and to the abuse of provisions found in a tax treaty. Further, where the Minister can establish abusive tax avoidance under the GAAR, s. 245 of the Income Tax Act applies to deny the tax benefit even where the tax arrangements are consistent with a literal interpretation of the relevant provisions.

The court then explained that applying the GAAR involves a three-part process to determine:

1) Whether there is a tax benefit arising from a transaction;

2) Whether the transaction is an avoidance transaction; and

3) Whether the avoidance transaction is abusive.

In Alta Luxembourg’s case, only the third part of the above determinations was at issue, which the court stated required a further two-step inquiry to examine the following:

1. The interpretation of the provisions relied on for the tax benefit to determine their object, spirit, and purpose; and
2. A factual analysis to determine whether the avoidance transaction was consistent with or frustrated the object, spirit, and purpose of the provisions.

Further, the court noted that the onus rested on the Minister to demonstrate the object, spirit, and purpose of the relevant provisions and to establish that allowing Alta Luxembourg the benefit of the exemption would be a misuse or abuse of the provisions.

Finally, the court explained that pursuant to previous case law, abusive tax avoidance is deemed to occur “when a taxpayer relies on specific provisions of the Income Tax Act in order to achieve an outcome that those provisions seek to prevent” or when a transaction “defeats the underlying rationale of the provisions that are relied upon”. Additionally, abusive tax avoidance can occur when an arrangement “circumvents the application of certain provisions, such as specific anti-avoidance rules, in a manner that frustrates or defeats the object, spirit or purpose of those provisions”.

Supreme Court of Canada Rules finds No Abusive Tax Avoidance and Dismisses Appeal

On the first step of its analysis, the court concluded that the object, spirit, and purpose of the relevant Treaty provisions was to:

“[F]oster international investment by exempting residents of a contracting state from taxes in the source state on capital gains realized on the disposition of immovable property in which a business was carried on, or on the disposition of shares whose value is derived principally from such immovable property.”

The court found that the result of Alta Luxembourg not being taxed for capital gains in Luxembourg and avoiding taxes under the carve-out provided by the Treaty, effectively resulting in double non-taxation, was consistent with the bargain struck between Canada and Luxembourg. The court found that Canada had explicitly agreed to forego its right to tax such capital gains, regardless of whether they would be taxed in Luxembourg, in order to attract foreign investment and to reap the economic benefits generated by that investment. As such, the court found that Canada had been aware of tax planning strategies using conduit corporations in Luxembourg, but had nonetheless made a deliberate choice not to include anti-avoidance provisions that would have addressed such a situation in the Treaty.

As to the second step of examining the factual context, the court held that the Minister had failed to discharge its burden of establishing that the avoidance transaction defeated the underlying rationale, the “object, spirit, or purpose”, beyond the words of the provisions. It found that the relevant provisions had operated as they had been intended to and there had been no abuse. Therefore, the court concluded that the GAAR could not be applied to deny the tax benefit claimed.

In the result, the court dismissed the appeal.

Contact Mark Feigenbaum for Experienced Advice on Tax Matters

Mark Feigenbaum brings together many years of litigation experience with a deep knowledge of tax law, corporate law, accounting, finance, and significant cross-border experience to make him uniquely positioned to assist you. Mark offers services to clients in the U.S., Canada and around the world. Contact Mark online or call him at (416) 777-8433 or toll-free at (877) 275-4792 to book a consultation.