Two Spectrums in the Canadian Tax Planning Behaviour
There are two spectra in Canadian tax planning behaviour. On the one side, there is unacceptable tax planning activities, which to say those that fall afoul of the general anti-avoidance rule (GAAR). This is of course very separate and distinct from tax evasion. For example, one of the primary criminal offences in tax, commonly referred to as the tax evasion offence, can be found in section 239 of the Canada Tax Act.
On the other side of the spectrum is acceptable tax planning. Acceptable tax planning is generally where the taxpayer engages in a tax saving or tax deferral strategy that complies with the Canadian Tax Act and case law.
The General Anti-Avoidance Rule Explained
There are cases where the taxpayer’s tax planning activities technically comply with the law, but not its spirit. The Canadian Tax Act contains GAAR to prevent these types of tax planning activities – those that comply with the law but abuse the Canadian Tax Act and/or Canadian tax treaties. In other words, the purpose of GAAR is to prevent abusive tax avoidance transactions while not interfering with legitimate tax avoidance transactions.
In order for the GAAR to be applicable, there are certain conditions that must be met. First, there must be a tax benefit enjoyed or realized during the taxation year. Second, the taxable benefit must have been a result from an avoidance transaction. Third, the transaction in question must have resulted in a misuse of the Canada Tax Act.
The finding of a misuse of the Canada Tax Act is essentially a two-pronged approach. First, one must interpret the object, spirit and purpose of the provision that gave rise to the tax benefit. Second, one must determine whether the transaction in question frustrates the purpose of the provision by examining the factual context. If the GAAR applies, then the CRA as guided by the courts, has the ability to deny the tax benefit.
On November 26, 2021, the Supreme Court of Canada released its decision in Canada v. Alta Energy Luxembourg S.A.R.L. regarding the application of the GAAR to Canadian tax treaties.
Facts in Canada v. Alta Energy Luxembourg S.A.R.L.
In 2011, Alta Energy Partners Canada Ltd. (“Alta Canada”) was incorporated in Canada as a wholly owned subsidiary of a US corporation, Alta Energy Partners LLC (“Alta U.S.”). Alta Canada was incorporated to a carry-on oil and gas exploration work in Alberta, Canada. If Alta U.S. was to sell Alta Canada shares, then as a non-resident for Canadian tax purposes, gains from the sale Alta Canada shares would be taxable in Canada under section 2 and 115 of the Canada Tax Act. These provisions provide that a non-resident will have to pay taxes on the gains on taxable Canadian property unless the property constitutes treaty protected property. Under the Canada-US tax treaty, Alta Canada shares were not treaty protected property. Therefore, if Alta U.S. was to sell Alta Canada shares, then any gains would be taxable pursuant to the Canada Tax Act in conjunction with the Canada-US tax treaty.
However, under the Canada-Luxembourg tax treaty, Alta Canada shares may constitute treaty protected property. Article 13(4) of the Canada-Luxembourg tax treaty, states that Canadian tax arising from a capital gain on the disposition of shares where the shares derive their value from immovable property in Canada will be exempted for residents in Luxembourg.
To take advantage of this tax planning opportunity, a corporate restructuring occurred in 2012, which involved incorporating Alta Energy Luxembourg S.A.R.L. (“Alta Luxembourg”) and then transferring Alta Canada shares from Alta U.S. to Alta Luxembourg.
By 2013, Alta Canada shares appreciated in value and Alta Luxembourg sold the shares and realized a capital gain of $380 million dollars. Alta Luxembourg took the position that the gain was not taxable in Canada by virtue of section 2 and 115 of the Canada Tax Act and article 13(4) of the Canada-Luxembourg Tax Treaty. The Canada Revenue Agency denied the treaty exemption. The CRA argued that the tax treaty exemption did not apply and even if the shares did constitute tax-protected property, the GAAR would apply. If the GAAR would apply, subsection 245(2) would provide the CRA the ability to deny the tax benefit and provide other reasonable tax consequences.
The Decisions from the Tax Court of Canada and the Federal Court of Appeal
Both the Tax Court of Canada and the Federal Court of Appeal held that the gain as a result of the disposition of Alta Canada shares was not taxable. The Courts held that Alta Luxembourg was entitled to the Canada-Luxembourg tax treaty benefits. The Courts also stated that the GAAR did not apply.
At both courts, Alta Luxembourg conceded that there was a tax benefit that resulted from an avoidance transaction. The main issue with respect to the potential application of the GAAR was whether the tax planning constituted a misuse or abuse of either the Act and/or the treaty.
The Tax Court of Canada and the Federal Court of Appeal both held that the object, spirit and purpose of the tax treaty was clear. Both Courts stated that the transaction in question did not frustrate the object, spirit and purpose of the tax treaty. Moreover, the courts stated that tax treaty shopping was not abusive. They stated that there is nothing improper with selecting one foreign regime over another for tax planning purposes.
The Decision From the Supreme Court of Canada
In a 6-3 decision, the majority of the Supreme Court of Canada agreed with the courts below that the CRA did not discharge its burden to prove that there was abusive tax avoidance. Therefore, the Court held that the transaction in question was a legitimate tax planning structure.
The CRA argued that the transaction at issued abused the Canada-Luxembourg Tax Treaty. The CRA stated that the treaty never intended to benefit residents without sufficient substantive economic connections to their state of residence. Alta Luxembourg on the other hand, argued that the CRA failed to discharge the burden of establishing that the object, spirit, or purpose of the tax treaty provisions was defeated.
In this case, since Alta Luxembourg admitted the existence of a tax benefit and an avoidance transaction, the only issue at dispute was whether the transaction had an abusive nature. As explained above, determining whether a transaction is abusive requires a two-tiered approach. First, one must interpret the object, spirit and purpose of the provision that gave rise to the tax benefit. Second, one must determine whether the transaction in question falls within or frustrates the purpose of the provision by examining the factual context.
The Supreme Court of Canada noted some principles relating to the GAAR analysis. First, the Court stated that tax avoidance should not be conflated with tax abuse. The Court said that just because a transaction is a tax avoidance transaction, it does not necessarily mean that the transaction is abusive within the meaning of the GAAR. Second, the Court also distinguished between immoral and abusive transactions. The Court stated that the GAAR abuse analysis should not be a value judgment of right and wrong. Rather, taxpayers have the right to organize their tax affairs to minimize tax liability as long as their tax planning is not abusive within the meaning of the GAAR. Therefore, the Court stated that although one may view that treaty shopping is immoral, treaty shopping in of itself is not necessarily abusive.
The Supreme Court of Canada first analyzed the object, spirit, and purpose of article 1 and 4(1) of the Canada-Luxembourg Tax Treaty which deal with residency requirements. The Court stated that based on the wordings of article 1 and 4(1), a resident is a person who is liable to tax in one or both of the contracting states (in this case, Canada and Luxembourg), and that the resident can have access to treaty benefits. The Court also rejected the sufficient substantive economic connections rationale put forth by the CRA. The Court stated that if the treaty drafters intended to benefit only corporations with sufficient substantive economic connections, they would have signalled such intention in the treaty.
The Supreme Court of Canada then analyzed the object, spirit and purpose of article 13(4) and (5) of the Canada-Luxembourg Tax Treaty, which deal with the exemption of capital gains tax on the disposition of shares where the shares derive their value from immovable property in Canada. The Supreme Court of Canada stated that Canada and Luxembourg made a deliberate choice to deviate from the OECD model treaty by including a carve-out provision for immovable property. This carve-out provision allows a person’s residence state to tax capital gains realized on the disposition of shares deriving their value principally from immovable property used in the person’s business. In the Court’s perspective, it was clear that Canada decided to forego its right to tax such capital gains based on broad economic considerations. The Court stated that Canada sought to increase employment and economic investment in Canada by providing this carve-out provision to foreign investors. The Court said that this tax benefit was not limited to residents of Luxembourg with sufficient substantive economic connections to Luxembourg.
Therefore, the Supreme Court of Canada held that the CRA did not discharge its burden to prove that there was abusive tax avoidance. It was a tremendous win for Alta Luxembourg since the transaction in question was ruled as a legitimate tax planning opportunity.
Pro Tax Tip: Taxpayers Have the Right to Choose Tax Treaties and Claim Benefits
The purpose of the GAAR is to prevent abusive tax planning activities that technically comply with the law but abuses the Canadian Tax Act and/or Canadian tax treaties. The GAAR bars abusive tax avoidance transactions. Although taxpayers are generally entitled to arrange their affairs to be as tax efficient as possible, if a transaction is too abusive within the meaning of GAAR, then the transaction in question may be challenged and ignored by CRA. This landmark case confirms that treaty shopping is not abusive within the meaning of the GAAR. Generally speaking, it confirms that the GAAR will only apply in situations where the abuse of the tax treaty or Canadian Tax Act is clear. Treaty shopping in of itself is not necessarily abusive, and taxpayers have the right to shop for treaties and claim the applicable benefits. If you have questions on cross-border transactions and the application of the GAAR thereof, contact an expert Canadian tax lawyer for legal advice.
"This article provides information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions you should consult a lawyer."