Tax Court of Canada Rules that Vendor Avoids Derivative Tax Liability When Selling Property to Tax-Motivated Arm’s-Length Buyer; The Transaction Also Failed to Trigger the General Anti-Avoidance Rule

Introduction: Damis Properties Inc. v. The Queen, 2021 TCC 24

In Damis Properties Inc. v. The Queen, 2021 TCC 24, the taxpayer sold shares of a company that had an accumulated tax liability exceeding the company’s after-tax net value. The buyer, an arm’s-length party, was willing to pay a premium because the buyer believed that it could reduce or eliminate the target company’s tax liability through tax-sheltering activities. The Canada Revenue Agency attempted to collect upon the target company’s tax debt by assessing the taxpayer for derivative tax liability under section 160. As an alternative, the CRA’s Canadian tax litigation lawyer invoked the general anti-avoidance rule (GAAR). Yet the Tax Court of Canada decided that neither section 160 nor the GAAR applied. The parties dealt at arm’s length, and while the court was not convinced that the tax-shelter strategy was effective, that issue fell upon the buyer, not the vendor taxpayer. The Damis Properties decision illustrates the importance of retaining an expert Toronto tax planning lawyer to ensure any proposed tax-motivated transactions will withstand CRA scrutiny and assault.

This article begins by introducing the derivative-tax provisions under section 160 of Canada’s Income Tax Act and the general anti-avoidance rule under section 245 of Canada’s Income Tax Act. It then analyzes the Tax Court of Canada’s decision in Damis Properties Inc. v. The Queen, 2021 TCC 24. Afterwards, it provides pro tax tips from our top Toronto tax lawyers, and it answers some frequently asked questions.

Derivative Tax Liability: Section 160 of Canada’s Income Tax Act

Section 160 of Canada’s Income Tax Act is a tax collection tool. It thwarts taxpayers who try to hide assets from the Canada Revenue Agency’s tax collector by transferring those assets to friends, relatives, related corporations, or shareholders.

Section 325 of the Excise Tax Act contains a similar rule relating to derivative liability for GST/HST debts. Hence, section 160 of the Income Tax Act bestows derivative income-tax liability for transfers by a person with income-tax debts; section 325 of the Excise Tax Act bestows derivative GST/HST liability for transfers by a person with GST/HST debts.

Section 160 applies if all the following four conditions are satisfied:

1. A property was transferred. The language of section 160 contemplates a broad range of transfers including dividend payments: it covers situations where a tax debtor “transferred property, either directly or indirectly, by means of a trust or by any other means whatever.”
2. At the time of the transfer, the transferor owed a tax debt to the Canada Revenue Agency.
3. The recipient was, at the time of the transfer, one of the following: (a) the transferor’s spouse or common-law partner (or a person who has since become the transferor’s spouse or common-law partner); (b) a person who was under 18 years of age; or (c) a person with whom the transferor was not dealing at arm’s length—e.g., a trust or corporation in which the transferor has an interest.
4. The recipient paid the transferor less than fair market value for the transferred property.

In simpler terms, section 160 applies when you receive assets from a related party who owes taxes, and you don’t give full consideration in return. For example, this could happen if you receive a dividend from a corporation with tax debts, or if you receive a gift of cryptocurrency or non-fungible tokens from a friend or relative with tax debts.

When section 160 applies, both the transferor and the recipient become “jointly and severally” responsible for the transferor’s tax debt. This makes the recipient independently liable for the tax debt from the moment of the transfer. Consequently, the Canada Revenue Agency’s tax collectors can pursue both the original tax debtor and the derivative tax debtor to collect the tax debt. Even if the original tax debtor is discharged from bankruptcy and relieved of the underlying tax debt, the derivative tax debtor remains liable to the CRA until the tax debt is fully paid.

Section 160 is a notoriously harsh rule: It offers no due-diligence defence, it applies even if the transaction wasn’t motivated by tax avoidance, and it catches transferees who don’t even realize that they’re receiving property from a tax debtor (e.g., see: Canada v Heavyside, 1996 CanLII 3932 (FCA), at para 3). In addition, section 160 doesn’t contain a limitation period. So, the Canada Revenue Agency can assess you under the rule years after the purported transfer.

Still, there are a few limits to the transferee’s derivative tax liability. The transferee’s derivative tax liability under section 160 is capped at the fair market value of the transferred property. The recipient’s liability is also offset by the amount of any consideration that the recipient provided for the property.  Say, for example, that a corporation owes $1 million in tax debt to the CRA, and it pays a $25,000 dividend to a shareholder, and it pays another $25,000 in salary to an employee. The shareholder’s derivative liability under section 160 is $25,000—i.e., the value of the dividend. The employee, however, doesn’t incur any derivative liability under section 160 because the employee provided consideration for the $25,000 salary—namely, the employee’s services.

Subsection 160(3) governs how payments apply to discharge the joint liability. A payment by a taxpayer who has inherited liability under section 160 will reduce both debts—that is, this payment reduces not only the tax debt of the jointly liable third-party taxpayer but also the tax debt of the original tax debtor. But an ordering rule governs a payment by the original tax debtor. The original tax debtor must first pay off all tax debts exceeding the joint debt. In other words, before her tax payments can discharge the joint debt, the original tax debtor must first pay off all tax arrears belonging solely to her. Only then can the original debtor’s payments extinguish the joint debt.

The General Anti-Avoidance Rule (the GAAR): Section 245 of Canada’s Income Tax Act

Section 245 of Canada’s Income Tax Act contain the provisions relating to the general anti-avoidance rule (also known as the “GAAR”). These provisions allow the Canada Revenue Agency to deny a tax benefit—i.e., tax reduction, tax avoidance, or tax deferral—arising from an abusive avoidance transaction or from a series of transactions that included an abusive avoidance transaction.

The Income Tax Act contains many specific anti-avoidance rules. These rules preclude taxpayers from taking advantage of specific loopholes that would otherwise be available. The GAAR, however, stems from the concern that it’s impossible to plug every legislative loophole, so the tax system requires a general rule to fill in the gaps. Thus, unlike the specific anti-avoidance rules, which are drafted using highly technical language dictating specific consequences, the GAAR is a broadly drafted provision.

Subsection 245(2) sets out the basic rule: “Where a transaction is an avoidance transaction, the tax consequences to a person shall be determined as is reasonable in the circumstances in order to deny a tax benefit that, but for this section, would result, directly or indirectly, from that transaction or from a series of transactions that includes that transaction.”

According to Supreme Court of Canada decisions, the GAAR applies only if three conditions have been satisfied:

1. The taxpayer enjoyed a “tax benefit” resulting from a transaction or part of a series of transactions. (A “tax benefit” encompasses any reduction, avoidance, or deferral of tax.)
2. The transaction was an “avoidance transaction,” which refers to a transaction that isn’t undertaken or arranged primarily for a bona fidepurpose other than to obtain a tax benefit.
3. The tax avoidance must have been “abusive,” which means that the resulting tax benefit would contravene the “object, spirit, or purpose” of the tax provisions relied upon by the taxpayer.

If the GAAR applies, then the Canada Revenue Agency may essentially take any “reasonable” step to deny the resulting tax benefit. Subsection 245(5) provides the following non-comprehensive list of remedies that the CRA may invoke:

• Allow or deny, in whole or in part, any deduction, exemption, or exclusion for the purposes of computing the taxpayer’s income, taxable income, taxable income earned in Canada, or tax payable;
• Allocate to “any person” (which means that the person need not be the taxpayer who entered the avoidance transaction or who enjoyed the resulting tax benefit) any deduction, exemption, exclusion, income, loss, or other amount or part thereof;
• Recharacterize the nature of any payment or other amount (for example: recharacterizing a half-taxable capital gain as fully taxable business income); and
• Ignore the tax effects that would otherwise result from applying any other provision of the Income Tax Act.

The above-listed remedies demonstrate that the GAAR gives the CRA a great deal of power. What’s more, the Canada Revenue Agency may invoke the GAAR even if a taxpayer has fully complied with the provisions in Canada’s Income Tax Act.  This is because the GAAR asks not whether a transaction satisfied the concrete language describing the impugned tax rule, but whether the transaction violated the tax rule’s unwritten “object, spirit, or purpose.” For this reason, the Canada Revenue Agency bears the burden of proving that the taxpayer violated the object, spirit, or purpose of the tax rule that facilitated the avoidance transaction. The taxpayer, however, bears the burden of disputing the existence of a tax benefit and an avoidance transaction.

The Supreme Court of Canada appreciates that the GAAR has the potential to undermine certainty for taxpayers attempting to plan their affairs. To that end, the Court warns the judiciary “to be careful not to conclude too hastily that simply because a non-tax purpose is not evident, the avoidance transaction is the result of abusive tax avoidance. […] [T]he GAAR was not intended to outlaw all tax benefits; Parliament intended for many to endure. The central inquiry is focussed on whether the transaction was consistent with the purpose of the provisions of the Income Tax Act that are relied upon by the taxpayer […]. Abusive tax avoidance will be established if the transactions frustrate or defeat those purposes.” (Canada Trustco, 2005 SCC 54, at para 57.) The Court also makes it clear that “the abusive nature of the transaction must be clear,” and that “if the existence of abusive tax avoidance is unclear, the benefit of the doubt goes to the taxpayer.” (Ibid., at paras 62 and 66).

Canadian Parliament, Canadian courts, the Minister of National Revenue, and the Canada Revenue Agency all recognize the significance of consistent application of the GAAR. To ensure this consistency, a GAAR Committee has been established by the Department of Finance, the Department of Justice, and the CRA. Comprised of officials from these entities, the GAAR Committee reviews all files where the GAAR might apply and makes decisions on issuing GAAR-based rulings or reassessments. These files often originate from the CRA’s Audit Division, which refers GAAR-specific issues to the GAAR Committee. Additionally, the GAAR Committee handles cases brought by taxpayers themselves, such as when a taxpayer seeks an advance ruling on whether a specific transaction will trigger a GAAR-based assessment by the CRA.

Damis Properties Inc. v. The Queen, 2021 TCC 24

In Damis Properties Inc. v. The Queen, 2021 TCC 24, the taxpayer’s Canadian tax-planning lawyers structured a transaction allowing the taxpayer to effectively sell shares in a company that had an accumulated tax liability exceeding the company’s after-tax net value. The buyer, an arm’s-length party, didn’t mind paying a premium because the buyer believed that it could reduce or eliminate the target company’s tax liability through tax-sheltering activities.

The taxpayer owned a stake in a general partnership that held farmland. To facilitate the taxpayer’s sale of the partnership to the buyer, the parties engaged in a series of transactions, which unfolded as follows:

1. The taxpayer transferred its partnership interest to a newly created corporation (Newco).
2. The partnership then sold the farmland for cash, allocating the income from the sale to Newco and distributing the cash to Newco.
3. Newco increased the paid-up capital (PUC) of its shares by the amount of net cash that it received from the partnership. This resulted in a corresponding increase to the adjusted cost base (ACB) of the taxpayer’s shares in Newco.
4. The taxpayer and the buyer agreed that the taxpayer had an option to put the Newco shares to the buyer for a cash payment equalling the taxpayer’s ACB for the Newco shares.
5. The sole director and officer of Newco resigned and was replaced by the buyer’s nominee. Newco’s new director caused the Newco to acquire software, thereby creating a tax shelter.
6. The taxpayer exercised the put option, and the buyer acquired the Newco shares, paying the purchase price to the taxpayer using Newco’s cash.

The Canada Revenue Agency reassessed the taxpayer, contending that the payment from Newco had caused the taxpayer to inherit Newco’s tax debts under section 160 of Canada’s Income Tax Act.  The Canada Revenue Agency’s main concern was that Newco’s tax liability remained unpaid. The buyer used a tax-shelter strategy when filing Newco’s return, resulting in no tax payable. Afterward, the buyer extracted funds from Newco in a manner that avoided section 160 liability. If the CRA denies the tax-shelter benefits by reassessing Newco, the reassessed tax liability would render Newco insolvent, and the Canada Revenue Agency tax collectors will get little to none of Newco’s tax debt. As a result, the CRA’s tax collectors issued a derivative-tax assessment to the vendor under section 160, viewing this option as offering a better chance of collecting the taxes.

The CRA’s alternative position was that the series of transactions fell victim to the general anti-avoidance rule (GAAR). The Canada Revenue Agency argued that the series of transactions aimed to circumvent the derivative tax liability under section 160, and the transactions were therefore abusive tax-avoidance transactions.

After hearing the arguments from the taxpayer’s Canadian tax-litigation lawyer, the Tax Court of Canada quickly dispatched the CRA’s derivative-tax assessment under section 160. The court determined that section 160 failed to impose any derivative-tax liability on the taxpayer during the successful sale of Newco shares to the buyer. The court offered two reasons for this decision: First, the taxpayer and the buyer dealt at arm’s length. Second, the buyer paid fair market value for the Newco shares. Either of these reasons alone would have sufficed to dismiss the section 160 assessment.

The Tax Court of Canada also decided that that the GAAR failed to apply. The court based its GAAR decision on two findings: First, the transactions between the taxpayer and the buyer formed part of an arm’s-length commercial deal, and section 160 doesn’t capture arm’s-length transactions. The transactions therefore didn’t abuse section 160, and the GAAR doesn’t apply absent a transaction that abuses the purpose of a specific tax rule. Second, the CRA’s Canadian tax-litigation lawyer’s contention that Newco solely existed to sell the tax liability to the buyer contradicted the presence of any tax benefit or avoidance transaction: The CRA’s argument implicitly acknowledged that Newco would never distribute dividends to the taxpayer.

Pro Tax Tips – Surviving Tax Litigation Involving the General Anti-Avoidance Rule or Derivative-Tax Assessments

If you receive dividends from corporation with outstanding income-tax debts or GST/HST debts, you’re exposed to derivative-tax liability under section 160 of the Income Tax Act or section 325 of the Excise Tax Act. There are several common strategies for challenging a derivative-tax assessment under section 160 or section 325. For example, you might challenge whether the corporation owed tax at the time it paid the dividend. Or as Damis Properties decision illustrates, you may establish that you and the payor dealt at arm’s length at the time of the payment. In any event, your response will succeed only if it aligns with the governing legal principles and finds support in the available evidence. Consult one of our expert Canadian tax lawyers for advice on reducing your exposure to a derivative-tax assessment under section 160 of Canada’s Income Tax Act or section 325 of Canada’s Excise Tax Act.

The Damis Properties decision also illustrates the importance of seeking an experienced Canadian tax-litigation lawyer. In Damis, the CRA’s Canadian tax-litigation lawyer raised alternative arguments, invoking not only derivative-tax liability under section 160 but also the general anti-avoidance rule under section 245 of Canada’s Income Tax Act. Moreover, as we’ve recently seen in cases like Choptiany et. al. v The King, 2022 TCC 112, the CRA’s tax counsel at the Department of Justice may employ pre-trial tactics aimed at misleading the other side and undermining the discovery process. If faced with such tactics, the average Canadian taxpayer will have little recourse without a top Canadian tax litigator, who can ensure that the Canada Revenue Agency conducts itself properly during the tax-litigation process.

FREQUENTLY ASKED QUESTIONS

I’ve heard that Canada’s tax law contains a general anti-avoidance rule. Can you explain this rule? 

Section 245 of Canada’s Income Tax Act contain the provisions relating to the general anti-avoidance rule (also known as the “GAAR”). These provisions allow the Canada Revenue Agency to deny a tax benefit—i.e., tax reduction, tax avoidance, or tax deferral—arising from an abusive avoidance transaction or from a series of transactions that included an abusive avoidance transaction.

Basically, the GAAR applies only if three conditions have been satisfied:

1. The taxpayer enjoyed a “tax benefit” resulting from a transaction or part of a series of transactions. (A “tax benefit” encompasses any reduction, avoidance, or deferral of tax.)
2. The transaction was an “avoidance transaction,” which refers to a transaction that isn’t undertaken or arranged primarily for a bona fidepurpose other than to obtain a tax benefit.
3. The tax avoidance must have been “abusive,” which means that the resulting tax benefit would contravene the “object, spirit, or purpose” of the tax provisions relied upon by the taxpayer.

If the GAAR applies, then the Canada Revenue Agency may essentially take any “reasonable” step to deny the resulting tax benefit. For example, the CRA can allow or deny, in whole or in part, any deduction, exemption, or exclusion for the purposes of computing the taxpayer’s income, taxable income, taxable income earned in Canada, or tax payable; or the CRA can recharacterize the nature of any payment or other amount (for example: recharacterizing a half-taxable capital gain as fully taxable business income).

I own a corporation that owes a large income-tax debt to the Canada Revenue Agency. I understand that, under Canadian tax law, a corporation and its shareholder are two distinct taxpayers. So, to protect the corporate assets from CRA tax collectors, I plan on paying all the corporation’s cash to myself as a dividend. This shouldn’t pose a problem, correct?  

You’ll expose your yourself to derivative tax liability under section 160 of Canada’s Income Tax Act. Section 160 is a tax collection tool, and it aims to thwart taxpayers who try to keep assets away from the Canada Revenue Agency by transferring those assets to related parties—such as shareholders. If your corporation pays all its cash to you as a dividend, section 160 allows the CRA’s tax collectors to pursue you for your corporation’s income-tax debts. Your derivative tax liability under section 160 is capped at the amount of the dividend (assuming that the dividend is less than the corporation’s income-tax debt).

I recently received a notice of reassessment, and I want to dispute this reassessment in the Tax Court of Canada. Should I hire a Canadian tax-litigation lawyer? Or is tax litigation something that I can handle myself?

Canadian tax litigation involves numerous procedural rules governing almost every aspect of the lawsuit, including specific deadlines, acceptable evidence, settlement negotiations, and the contents of pleadings. What’s more, the substantive tax issues are often themselves very complicated, involving intricate, sometimes convoluted tax legislation. As a result, we highly recommend that you avoid representing yourself. Consult one of our skilled Canadian tax-litigation lawyers who can simplify the tax-litigation process, review your evidence, get you ready for depositions, prepare your case for Tax Court, and represent you before the Tax Court of Canada during the hearing or settle your appeal with the Canadian tax-litigation lawyer representing CRA and the CRA before a hearing.

DISCLAIMER: This article just provides broad information. It is only up to date as of the posting date. It has not been updated and may be out of date. It does not give legal advice and should not be relied on. Every tax scenario is unique to its circumstances and will differ from the instances described in the article. If you have specific legal questions, you should seek the advice of a Canadian tax lawyer.

About the Author

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David J. Rotfleisch

David J. Rotfleisch, a leading Canadian tax lawyer, is not only a certified specialist in taxation but also a chartered professional accountant. Most recently, David is a pioneer in Canadian crypto taxation.

As of April 2020, he was one of 12 Ontario Certified Specialists In Taxation™.

Learn more about David J. Rotfleisch