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Copthorne — Supreme Court upholds lower courts’ decisions and applies the GAAR


Canadian Tax Alert, December 20, 2011

Copthorne Holdings v. Canada [1], the latest Supreme Court of Canada decision on the general anti-avoidance rule (GAAR)[2], was unanimous, well written and clear. With this decision, the court reestablished the unanimity of approach to analyzing the GAAR as expressed in Canada Trustco[3] and Mathew[4]. However, as should have been expected, it did not provide certainty as to the application of the GAAR or the determination of the existence of a series of transactions.

This case involved the restructuring of a corporate group whereby, inter alia, a Netherlands incorporated entity converted a wholly-owned Canadian subsidiary (Copthorne I) and its wholly-owned Canadian subsidiary (VHHC Holdings) into sister corporations which were subsequently amalgamated (Copthorne II). This was achieved by the sale by Copthorne I of the shares in VHHC Holdings to the Netherlands incorporated parent, followed by a horizontal amalgamation of the two Canadian corporations. The result of this restructuring was that the sizeable paid-up capital (PUC) of VHHC Holdings was preserved on the horizontal amalgamation. As such, the PUC of the amalgamated corporation was significantly greater than the PUC would have been on a vertical amalgamation. Significant tax savings were subsequently realized on the redemption of shares due to this “doubling up” of PUC.

In affirming the decisions of the Tax Court of Canada and the Federal Court of Appeal, Justice Rothstein concluded that the GAAR was applicable to the series of transactions. Relying on the principles established by the court in Canada Trustco, he addressed the following issues:

  • Did a tax benefit result from the transaction?
  • If yes, was the transaction an avoidance transaction?
  • If yes, was the transaction an abuse or misuse of the Act?

Tax benefit
As “tax benefit” is broadly defined in the Act to include a reduction, avoidance or deferral of tax, it is perhaps not surprising that the court found that a tax benefit arose from the restructuring that increased the amount of PUC eligible for tax-free repatriation. The court stated that the existence of a tax benefit is determined by comparing the transactions undertaken with an alternative arrangement that might reasonably have been carried out but for the existence of the tax benefit. By comparing the simpler option of a vertical amalgamation with the chosen option of a horizontal amalgamation, Justice Rothstein determined that a tax benefit resulted and that the taxpayer did not meet the onus of refuting this finding.

Avoidance transaction
A transaction is defined to be an avoidance transaction if, whether alone or as part of a series of transactions, it results in a tax benefit and is not undertaken primarily for bona fide non-tax purposes.[5] Justice Rothstein considered the transactions in question in light of this definition, the common law definition of series, and subsection 248(10) of the Act which deems a series of transactions to include any related transactions completed “in contemplation of” the series.

As the tax benefit resulted from a number of transactions, i.e., the restructuring and the redemption of shares approximately a year later, it was necessary for the court to first determine whether the transactions constituted a series. The common law definition of series was summarized as requiring each transaction to be “pre-ordained to produce a final result”.[6] This narrow test is expanded by subsection 248(10) which Justice Rothstein concluded should be read both prospectively and retrospectively in determining whether a transaction is part of a series of transactions.[7] Therefore, it was concluded that the subsequent share redemption was completed “in contemplation of” the earlier restructuring.

Consistent with the approach taken by the Federal Court of Appeal, Justice Rothstein stated that a “strong nexus” between the transactions is not needed for subsection 248(10) to apply; however, the “because of” or “in relation to” test established in earlier cases interpreting the application of subsection 248(10)[8] does require more than a mere possibility or a connection with an extreme degree of remoteness. Each case would be determined after a review of the specific facts.

The next issue to be considered was whether the series of transactions included an avoidance transaction. The court found that the taxpayer failed to prove a bona fide non-tax purpose for the sale of the subsidiary to the Netherlands incorporated parent. Consequently, there was a series of transactions that resulted in a tax benefit and an avoidance transaction that was a part of the series.

Abuse or misuse of the Act
Justice Rothstein, citing Canada Trustco[9], noted that in order to identify whether a transaction abuses or misuses the Act, it is necessary to determine the “object, spirit or purpose” of the relevant provisions. This should be undertaken using the “unified, textual, contextual and purposive approach” to statutory interpretation, with due regard to the fact that in a GAAR analysis, understanding the underlying rationale of a provision is the key objective. Abusive tax avoidance will be found “(1) where the transaction achieves an outcome the statutory provision was intended to prevent; (2) where the transaction defeats the underlying rationale of the provision; or (3) where the transaction circumvents the provision in a manner that frustrates or defeats its object, sprit or purpose.”[10] The burden lies with the revenue authorities to establish that an avoidance transaction is abusive.

In this case, at issue was the application of subsection 87(3) of the Act, which deals with the determination of the PUC of the shares of an amalgamated corporation. Specifically, this subsection provides that the PUC of the shares of the amalgamated corporation may not exceed the PUC of the shares of the predecessor amalgamating corporations. However, for this computation, the shares of an amalgamating corporation that were owned by another amalgamating corporation are to be excluded. Thus, if a vertical amalgamation had been undertaken, the PUC of VHHC Holdings would not have carried forward to the amalgamated corporation.

As part of the contextual analysis of the object, spirit and purpose of subsection 87(3), Justice Rothstein noted that Parliament has enacted a number of provisions aimed at preventing an inappropriate PUC increase or preservation. He considered the “implied exclusion” argument, i.e., whether the fact that a particular transaction is not caught by these PUC provisions should lead to the conclusion that the transaction is not inconsistent with the purpose of these provisions. While he did not rule out the possibility that in some cases the underlying rationale of a provision would be no broader than the words of the statute, he rejected that argument in this case. He rationalized subsection 87(3) on the basis that a return of capital from an amalgamated company to its shareholders should only be possible to the extent that such payment reflects the investment made with tax-paid funds.

In his purposive analysis, Justice Rothstein noted that one cannot find abuse based on a broad statement of policy, such as anti-surplus stripping, which is not grounded to the provision in question. He concluded that the object, spirit and purpose of subsection 87(3) is to preclude preservation of the PUC of the shares of a subsidiary corporation upon amalgamation where it would result in a return of PUC in excess of the amounts invested in the amalgamating corporations with tax-paid funds.

Justice Rothstein found that the transactions resulted in an abuse of subsection 87(3) of the Act. The sale of the shares of VHHC Holdings to the Netherlands incorporated parent in order to protect the corporation’s PUC were determined to have circumvented the intended outcome of subsection 87(3) in a manner that frustrated or defeated its objective. As such, he affirmed the findings of the lower courts by concluding that assessment based on the GAAR was appropriate.

Applying the GAAR going forward

Copthorne reaffirms the principles set out in Canada Trustco which require a court to consider not only the words of a provision but also the context of the provision and the provision’s object, spirit and purpose, in deciding whether a transaction or series of transactions would be subject to the GAAR. The decision is very clearly written and provides an analytical roadmap for the GAAR. However, not surprisingly, it falls short of creating certainty as to when the GAAR would apply to a particular set of facts and circumstances. The very nature of statutory interpretation, especially in the context of the GAAR, likely makes certainty elusive if not impossible.

[1] 2011 SCC 63, December 16, 2011.
[2] Income Tax Act, RSC 1985, c. 1 (5th supp), section 245. All statutory references in the article are to the Income Tax Act (the Act).
[3] Canada Trustco Mortgage Co. v. Canada, [2005] 2 SCR 601.
[4] Mathew v. Canada, [2005] 2 SCR 643.
[5] Subsection 245(3).
[6] See paragraph 43 of the judgment.
[7] This interpretation was applied in Canada Trustco and OSFC Holdings Ltd. v. Canada, 2001 FCA 260.
[8] Canada Trustco and MIL (Investments) S.A. v. R., 2006 TCC 460 paragraph 62; aff’d 2007 FCA 236.
[9] Supra note 3, paragraphs 44, 47 and 55.
[10] Paragraph 72 of the judgment.


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