( Disponible en anglais seulement )
In its most recent decision involving the application of the general anti-avoidance rule (the “GAAR”), under section 245 of the Income Tax Act (Canada) (the “Act”) a unanimous Supreme Court of Canada (the “SCC”) applied the GAAR to a complex series of transactions that culminated in what would otherwise have been a tax-free share redemption. The share redemption at issue involved the redemption of shares of a Canadian resident corporation owned by a non-resident shareholder.
Copthorne Holdings Ltd. v. Canada (2011 SCC 63) (“Copthorne”) serves as a warning for taxpayers and tax planners that, even in circumstances where the taxpayer’s transactions are in strict compliance with the text of the relevant provision of the Act, Canadian courts may apply the GAAR to disallow abusive income tax avoidance. The unanimous Copthorne decision, both at the SCC and in the lower Courts, should strengthen Canada Revenue Agency’s (“CRA”) resolve to apply the GAAR as it deems appropriate.
The Transactions at Issue
The series of transactions at issue in Copthorne was complex and involved a multitude of corporations, transactions and investments. These transactions can be distilled into three essential features: (i) they occurred over a number of years; (ii) they involved a sale of shares and subsequent horizontal amalgamation that were structured to preserve the paid-up capital (“PUC”) of the shares of the amalgamating corporations; and (iii) they culminated in a tax-free redemption of shares of a Canadian resident corporation owned by a non-resident shareholder. The tax-free nature of the redemption was a result of the sale of shares and subsequent horizontal amalgamation that preserved PUC in the manner described below.
In a nutshell, the PUC of shares generally represents funds that have been invested by shareholders in a corporation, subject to certain adjustments under the Act. The PUC of shares of a Canadian resident corporation (other than a public corporation in certain circumstances) can be returned to the corporation’s shareholders tax-free. The general principle governing the PUC of shares is that capital investments that are made by shareholders in shares of Canadian resident corporations using after-tax dollars should not be taxed again when such capital is withdrawn.
For example, if a shareholder subscribes for shares in a Canadian resident corporation for $100 and the value of those shares increases to $105, the redemption of those shares by the corporation should result in a tax-free return of the PUC of $100 and a taxable distribution to the shareholder of $5. If that same shareholder subscribes for shares in two Canadian resident corporations for $100 each and those sister corporations are then amalgamated horizontally, the PUC of the shares of the amalgamated corporation that could be returned to the shareholder on a tax-free basis should generally be $200.
The potential for abuse arises in the context of multiple tiers of corporations. If a shareholder subscribes for shares of a Canadian resident corporation (referred to herein as “parent corporation”) for $100, and the parent corporation then uses these funds to subscribe for shares of a wholly-owned Canadian resident subsidiary (referred to herein as “subsidiary corporation”), the PUC of the shares of the parent corporation and the subsidiary corporation will be $100 each notwithstanding that only $100 was initially invested by the shareholder in the corporate structure. There is generally no limit to the amount of PUC that could be created in this manner by an initial investment through a number of tiered subsidiary corporations.
Subsection 87(3) of the Act effectively provides that on a horizontal amalgamation involving sister corporations the PUC of the shares of the amalgamated corporation is equal to the sum of the PUC of shares of the predecessor sister corporations. However, subsection 87(3) of the Act also prevents taxpayers from taking advantage of the potential duplication of PUC by effectively providing that, on a vertical amalgamation involving a parent corporation and its subsidiary corporation, the PUC of the shares of the subsidiary corporation is eliminated.
Put simply, the series of transactions in Copthorne involved the type of PUC duplication described above. The PUC duplication was achieved by arranging to have the parent corporation sell shares in its subsidiary corporation to the non-resident shareholder of the parent corporation, such that the parent corporation and the subsidiary corporation became sister corporations immediately prior to the amalgamation. In this manner, the PUC of the shares of the subsidiary corporation was preserved and could be returned to the non-resident shareholder of the amalgamated corporation without any Canadian withholding taxes. The shares of the amalgamated corporation were redeemed approximately one year after the horizontal amalgamation under review.
The SCC’s Analysis and Decision
CRA assessed the taxpayer in Copthorne on the basis that the series of transactions undertaken by the taxpayer was subject to the GAAR and resulted in a deemed dividend to the non-resident shareholder which was subject to Canadian withholding taxes. The Tax Court of Canada and the Federal Court of Appeal each upheld CRA’s assessment, save for a penalty (equal to 10% of the tax owing as a result of the deemed dividend) that had also been assessed by CRA.
The SCC upheld the decisions of the lower Courts and applied the analytical framework it had previously applied in another case involving the GAAR: Canada Trustco Mortgage Co. v. Canada (2005 SCC 54). The three questions to be decided in applying the GAAR were described as follows, with an affirmative answer to each being a prerequisite to the application of the GAAR: (i) Was there a tax benefit? (ii) Was the transaction giving rise to the tax benefit an avoidance transaction? and (iii) Was the avoidance transaction giving rise to the tax benefit abusive?
The first question – the existence of a tax benefit – was answered affirmatively on the facts of the case. The sale of the shares and the horizontal amalgamation that preserved the PUC of the shares of the amalgamating corporations and subsequent tax-free share redemption resulted in a tax benefit.
With respect to the second question, the SCC noted that the sale of the shares of the subsidiary corporation to the non-resident shareholder and the subsequent horizontal amalgamation that preserved the PUC of the shares of the amalgamating corporations did not, in and of themselves, result in a tax benefit. The tax benefit was only realized on the tax-free share redemption. Therefore, the SCC had to consider whether the share redemption transaction was part of the series of transaction that included the share sale to the non-resident shareholder and the subsequent horizontal amalgamation.
The SCC noted that subsection 248(10) of the Act provides that a series of transactions is deemed to include “any related transactions or events completed in contemplation of the series”. In what is perhaps the most significant conclusion in the judgment, the SCC found that the phrase “in contemplation of” could apply both prospectively and retrospectively. The SCC rejected the taxpayer’s argument that a subsequent transaction must be “contemplated by the parties” at the time of a prior transaction in order for the subsequent transaction to form part of the same series. Instead, the SCC confirmed its prior holding in the Canada Trustco case that it is sufficient for a later transaction to have been completed “because of” or “in relation to” an earlier transaction in order to be considered part of the same series, regardless of whether the later transaction was contemplated at the time of the earlier transaction. The SCC also rejected the findings of the Tax Court that a “strong nexus” is required to meet the series test but indicated that it does require more than a “mere possibility” or a connection with “an extreme degree of remoteness”.
On the relevance of the passage of time to the determination of the existence of a series of transactions, the SCC stated that “the length of time between the series and the related transaction may be a relevant consideration in some cases; as would intervening events taking place between the series and the completion of the related transaction.” However, the Court did indicate that, in the end, it will be the “because of” or “in relation to” test whether applied retrospectively or prospectively, on a balance of probabilities, which will ultimately determine whether a related transaction was completed in contemplation of a particular series.
The SCC agreed with the findings of the lower Courts that on a retrospective application of this test the redemption transaction was part of the same series of transactions as the prior sale of the shares of the subsidiary corporation to the non-resident shareholder and the subsequent horizontal amalgamation. The SCC also agreed with the conclusion of the lower Courts that the sale of the shares of the subsidiary corporation to the non-resident shareholder was an avoidance transaction because it had the effect of preserving the PUC of the shares of the sister corporations on the subsequent horizontal amalgamation and was not primarily undertaken for a bona fide non-tax purpose.
Finally, on the issue of whether the avoidance transaction had been abusive, the SCC held that the double counting of the PUC was abusive in this particular case because the taxpayer structured the transactions in order to artificially preserve the PUC in a way that frustrated the purpose of subsection 87(3) which provides that on a vertical amalgamation the PUC of shares of a subsidiary corporation is not preserved. Thus, the third question in the GAAR analysis was answered in the affirmative and the SCC upheld the decisions of the lower Courts and CRA’s assessment of Canadian withholding taxes on the deemed dividend resulting from the share redemption.
Takeaways from Copthorne Decision
The decision in Copthorne does not constitute a fundamental change to the analytical framework for the application of the GAAR. However, significant takeaways from the judgment include the SCC’s affirmation of the retrospective application of the phrase “in contemplation of”; the SCC’s willingness to consider a series of transactions extending over several years; and the clarification of the object, purpose and spirit of subsection 87(3) of the Act.
On this last point, it remains to be seen whether the SCC’s unanimous support of the integrity of the PUC regime will extend to transactions involving arm’s length share sales and reorganizations. The transactions in Copthorne involved non-arm’s length parties, but there could also be situations where PUC is preserved in a transaction involving arm’s length parties, where, for example, a third party unknowingly purchases a corporation with artificially-inflated PUC. The application of the GAAR requires a fact-specific analysis, and tax practitioners and taxpayers alike must always evaluate the potential application of the GAAR in light of their particular facts and circumstances.