The General Anti-Avoidance Rule (GAAR), set out in Section 245 of the Income Tax Act, was first introduced in 1988. Although Revenue Canada issued Information Circular 88-2 setting out their views of what is and is not covered by that Section, there have not been any judicial pronouncements until recently. In 1995, Revenue Canada was successful using the GAAR provisions of the Excise Tax Act. Revenue Canada has now had two successes under the Income Tax Act.
The Tax Court of Canada case of McNichol involved a surplus stripping arrangement. A holding company owned by 4 individual partners in a law firm sold its only asset, a building. Instead of removing the cash from the holding company by way of taxable dividends, the shareholders sold their shares to an arm’s length inactive company and claimed the capital gains exemption to shelter their gains on disposition.
Revenue Canada reassessed the taxpayers on the basis that GAAR applied to the sale of shares and taxed each shareholder as if he had received dividends rather than capital gains proceeds.
The Tax Court of Canada ruled that GAAR did apply. The sale of shares to the inactive company was an avoidance transaction lacking a bona fide purpose. The sale was intended to trigger a capital gain eligible for the exemption.
The Court held that the transaction was a misuse of the provisions calculating a taxpayer’s capital gain and capital gains exemption and an abuse of the provisions of the Act as a whole.
The Equilease decision involved an avoidance of non-resident withholding tax by dividend surplus stripping. The shares of a Canadian company were sold by a non-resident to a newly created unrelated corporation after the Canadian company had terminated its business operations and when its only assets were cash and accounts receivable.
The Tax Court of Canada found that the money received by the U.S. parent were winding up dividends because in substance they were “distributed or otherwise appropriated in any manner whatever” on the winding up of Equilease’s business. The Court held that, alternatively, the parties were not at arm’s length and the sale proceeds became deemed dividends. (Note that both of these arguments, made by Revenue Canada, were unsuccessful in McNichol.)
The Tax Court of Canada also held that if those rules were not applicable on their own terms, GAAR was applicable. The Court said that the Income Tax Act read as a whole envisions that a distribution of corporate surplus to shareholders should be taxed as dividends. A form of transaction otherwise devoid of commercial objectives whose real purpose is the extraction of corporate surplus and avoidance of the ordinary consequences is an abuse of the Act as a whole. The Court made this finding despite the fact that the taxpayer argued that the primary purpose behind the sale was U.S. tax savings, which exceeded the expected Canadian tax benefits.
The McNichol and Equilease decisions confirm Revenue Canada’s position in IC88-2 that GAAR applies if a shareholder realizes a capital gain instead of a dividend on a disposition of property if it is determined that the series of transactions was an avoidance transaction carried out to defeat the purpose of the provisions in question.
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