The General Anti-Avoidance Rule ("GAAR") contained in section 245 of the Income Tax Act, 1985, c. 1 (5th Supp.) (the "Tax Act") applies to deny a taxpayer a particular tax benefit or result where three conditions are satisfied: (1) the taxpayer enjoyed a "tax benefit"; (2) the taxpayer entered into an "avoidance transaction"; and (3) the taxpayer engaged in "abusive tax avoidance".
A "tax benefit" includes any reduction, avoidance or deferral of tax or a refund of tax or other amount under the Tax Act. An "avoidance transaction" is a transaction undertaken primarily for tax reasons and not for a bona fide commercial, family or charitable purpose where any tax savings are ancillary in the overall plan. Lastly, "abusive tax avoidance" exists where the transaction in question frustrates or defeats the object, spirit or purpose of the provisions relied on to realize the tax benefit.
In Lehigh Cement1 the court considered whether the loan restructuring undertaken by the Appellant constituted an abuse under GAAR of the interest withholding tax exemption contained in previous paragraph 212(1)(b)(vii). During the relevant time and prior to 2008, withholding tax applied to interest payments made by Canadian residents to non-residents subject to certain enumerated exceptions. One of these exceptions was contained in subparagraph (vii) which provided that interest payable by a corporation resident in Canada to an arm's length person not resident in Canada was not subject to withholding tax provided the payer was not obligated to pay more than 25% of the principal amount of the loan within 5 years from the date of the issue of the loan.
Since the relevant years under appeal, subsection 212(b) has been amended to greatly expand the circumstances in which interest payments made to non-residents will not be subject to withholding taxes. In respect of interest paid to arm's length parties the requirement that the payer be a Canadian corporation and restrictions on repayment of capital have been removed.
Notwithstanding the fact that the relevant income tax provision considered in Lehigh Cement has been amended, this case is still relevant because the key issue in this case, whether the Appellant circumvented the arm's length requirement in the exemption to withholding tax on interest payments, would still be relevant under the revised provision.
The relevant facts can be summarized as follows: (1) the Appellant was a Canadian corporation resident in Canada, but was controlled by a publicly traded German company, (2) the Appellant was indebted to a consortium of Canadian banks, (3) indirectly, this debt was eventually assigned to a Belgian company related to the Appellant ("Belgianco"), (3) Belgianco assigned its right to receive the interest payments ("Interest") to be paid by the Appellant under the debt for a five year period to an unrelated Belgian bank ("Bank"), and (4) treating the Interest as coming within subparagraph 212(1)(b)(vii), the Appellant did not withhold tax under Part XIII of the Tax Act.
The Canada Revenue Agency (the "CRA") took the position that the Appellant should have withheld tax on the Interest, assessed the Appellant under Part XIII and imposed a 10% penalty for failure to withhold under section 227 of the Tax Act. The basis for the CRA's position was that GAAR applied to the sale of the Interest to the Bank and the avoidance of withholding tax thereon.
At trial, the Appellant conceded that it had enjoyed a "tax benefit" and that the impugned transactions were "avoidance transactions" under GAAR. In considering whether the Appellant had engaged in "abusive tax avoidance", the last element required to trigger GAAR, the court held that the object, spirit and purpose of subparagraph 212(1)(b)(vii) was:
[T]o help Canadian corporations needing to borrow money by increasing their access to international capital markets. The cost of withholding tax on interest paid to foreign lenders is often shifted to the Canadian borrower, thereby increasing the cost of capital. The exemption from withholding tax on arm's length borrowing from foreign lenders makes such borrowing more competitive with domestic borrowing in Canada. 2
Justice M.A. Mogan for the court determined that "the Appellant did not borrow any money from [the Bank] or any other non-resident lender. The absence of a non-resident lender causes me to infer that the sale transaction between [Belgianco] and [the Bank] abused subparagraph (vii)."3 The court found that the relationship between the Appellant and the Bank was "wholly dissimilar to the arm's length borrower/lender relationship contemplated by subparagraph (vii)"4, and thus the Appellant, in avoiding withholding on the Interest had defeated or frustrated the object, spirit and purpose of the withholding tax exemption it had relied on.
Both the Appellant and CRA agreed that the Interest did qualify for the subparagraph (vii) withholding tax exemption. As such, CRA had to establish all three elements of GAAR to deny this exemption and assess the Appellant for a failure to withhold tax on the Interest. As the Appellant conceded the first two elements of GAAR (the avoidance of withholding tax was a "tax benefit" and the sale of the Interest was an "avoidance transaction"), CRA was only required to establish that the Appellant misused or abused subparagraph 212(1)(b)(vii) of the Tax Act. Given that the court found the object, spirit and purpose of subparagraph 212(1)(b)(vii) was to facilitate non-arm's length borrowings between Canadian companies and non-resident lenders, and the Appellant never actually borrowed any money from the Bank, it is not surprising that the Appellant failed at the "abusive tax avoidance" stage of GAAR.
Could the impugned transactions have been structured in such a manner as to defeat CRA's "abusive tax avoidance" position? Additionally, did the Appellant commit a strategic error in conceding the existence of an "avoidance transaction" or could the impugned transactions have been designed to support the proposition that they were undertaken primarily for non-tax reasons?
In terms of "abusive tax avoidance", if the Appellant had borrowed from the Bank directly and used the proceeds to repay Belgianco (assuming such an arrangement would have made business sense for Belgianco), there can be little doubt that the Appellant would have succeeded in defeating CRA's misuse and abuse claims.
In terms of "avoidance transaction", if Belgianco had developed a primary bona fide commercial purpose for the sale of the Interest to the Bank (i.e. Belgianco may have needed the cash to fund operations, expansions, acquisitions or debt repayments) and the Appellant had not conceded the existence of an "avoidance transaction", CRA's GAAR assessment would have likely failed.
This decision is a classic example of the need for taxpayers to solidify their non-tax reasons for undertaking a particular tax plan to the point where such non-tax reasons are predominant to an objective observer. The decision is also a reminder that it is imperative to always be mindful of the GAAR arrows in CRA's quiver and the usefulness of considering alternative structures which achieve the same economic result, but which may be more defensible when targeted.
1. Lehigh Cement Ltd. v. R., 2009 TCC 237, 2009 D.T.C. 776. Note that a Notice of Appeal regarding this decision has been filed with the Federal Court of Appeal.
Ibid. at 39.
3. Ibid. at 45.
4. Ibid. at 46.