Appellate court finds palpable and overriding error in Tax Court's judgment
A decision of the Federal Court of Appeal marks a departure from the strict notions of de jure and de facto control when applying the general anti-avoidance rule, says a lawyer focusing on tax audits, tax reassessments and taxpayer relief applications.
“The broader notion of ‘actual control’ allows the court to make a determination taking into account all the relevant circumstances of a case,” says Eric Luu, a lawyer from HKL Tax Law.
In Canada v. Deans Knight Income Corporation, 2021 FCA 160, the respondent was a Canadian public corporation with tax attributes comprising approximately $90 million of unused non-capital losses and other deductions. The respondent, alongside a new shareholder, intended to realize the value of such tax attributes through entering into an investment agreement with a venture capital company.
The investment agreement offered a framework for a tax attribute monetization arrangement. The respondent would transfer most of its existing business to the new shareholder except for its tax attributes. This shareholder would receive a specified amount and turn over to the venture capital company the reins to the respondent. The respondent then deducted most of its tax attributes to reduce its tax liability from 2009 to 2012.
After being denied these deductions and receiving reassessments, the respondent won its appeal to the Tax Court of Canada. The Crown appealed, contending that the monetization arrangement fell within the application of the general anti-avoidance rule (GAAR) and constituted abusive tax avoidance in breach of the Income Tax Act’s provisions restricting the use of tax attributes after an acquisition of control by a person or group of persons.
The Federal Court of Appeal allowed the Crown’s appeal and set aside the Tax Court’s judgment, finding that the statutory conditions for the application of the GAAR were met. The tax benefit should be denied under s. 245(2) of the Income Tax Act because it circumvented s. 111(5) in a way that frustrated the object, spirit and purpose of the latter provision, the appellate court ruled.
The appellate court noted that the following points were admitted and clear: There was a tax benefit comprising the deduction of the tax attributes, and there were avoidance transactions relating to the investment agreement, given that these transactions were part of a series that resulted in the tax benefit and were not undertaken primarily for bona fide purposes beyond acquiring such tax benefit.
The issue before the appellate court revolved around the third question in the GAAR analysis, namely whether there has been abuse, considering that the first two questions were not disputed.
The first step of the GAAR analysis is to determine the object, spirit and purpose of the provision relied upon, which in this case was s. 111(5) of the Income Tax Act. The appellate court found that the object, spirit and purpose of that provision is, at least partially, to restrict the use of specified losses, including non-capital losses, if a person or group of persons has obtained actual control over the corporation’s actions, whether through de jure control or other means. The appellate court replaced “effective control,” as used in the submissions, with “actual control.”
The second step of the analysis is to decide whether the transaction resulted in abuse that frustrated the purpose of s. 111(5). The appellate court found that the Tax Court’s conclusion on this matter was unsupported by the evidence and inconsistent with the investment agreement’s terms, which had resulted in the respondent and the new shareholder not being free actors because they handed over actual control of the respondent’s actions to the venture capital company.
The appellate court thus held that the error, in this case, met the high threshold for the applicable standard of review, which was whether there was a palpable and overriding error. The appellate court found the error palpable because it was plain to see that the Tax Court’s conclusion was inconsistent with the agreement’s terms. It was an overriding error because it impacted the result of the case, the appellate court added.
