The March 28, 2023 Federal Budget proposed numerous measures previously discussed in our Firm commentary, prepared on Budget night. This article expands on our initial analysis of the proposed amendments to the GAAR.
Table of contents
- Avoidance transaction
- Economic substance
- Reassessment period
- Timing for coming into force
- Concluding thoughts
Taxpayers are free to arrange their affairs to reduce their tax liability, obviously: it would be absurd if the government deemed every taxpayer's financial position as final at some point, like stopping the music in a game of fiscal musical chairs. The UK Royal Commission on the Taxation of Profits and Income said it best in 1954: "There is no reason to assume that the situation of any one taxpayer at that moment is the fairest possible as between himself and others differently situated [and] it seems wrong to propound any principle that would have the effect of fixing each taxpayer in his situation, without allowing him any chance of so altering his arrangement as to reduce his liability …" That said, tax planning subsists within a web of charging and relieving provisions, judicial anti-avoidance doctrines, and specific anti-avoidance rules (SAARs) that foreclose certain strategies. However, SAARs do not completely delineate the boundaries of legitimate planning and abusive avoidance.
A seminal 1988 paper credited to David Dodge (then Senior Assistant Deputy Minister of Finance) stated the case for a general anti-avoidance rule (GAAR): "… the main limits of the "specific rules" approach … are the practical impossibility of foreseeing every avoidance scheme, the fact that every new rule opens new loopholes, the inequity of adopting rules that may catch transactions that were not intended to be covered, the fact that specific rules outline particular schemes and may therefore help to develop other avoidance strategies and, finally, added complexity. Proposed section 245 is precisely intended to minimize the need to respond repeatedly to abusive strategies by enacting specific legislation every time a purely tax-motivated scheme is marketed."
Since the GAAR was enacted in 1988, it has been considered as an assessment basis in more than 1,600 cases and most of the time the CRA applied it as a primary or secondary assessing position. Numerous GAAR cases wind their way through the Tax Court of Canada and the Federal Court of Appeal annually. Recently, the Supreme Court of Canada gave judgment in its sixth GAAR appeal, in Deans Knight Income Corp. v. Canada. Five of those six Supreme Court cases involved domestic strategies and the Crown won in four of them – a good track record.
Despite the Crown's regular and successful use of the GAAR, the Trudeau government wanted change. The drivers seem to be political, rather than good tax policy.
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According to the federal Interpretation Act, "[t]he preamble of an enactment shall be read as a part of the enactment intended to assist in explaining its purport and object." Like most things in life and law, a preamble's weight depends on the circumstances and preambles can be important to purposive interpretation. This view assumes that judges need assistance or encouragement to undertake purposive analysis. Budget 2023 stated that the preamble would be added "in order to help address interpretive issues and ensure that the GAAR applies as intended." Given the reasons of a majority of the Supreme Court in Deans Knight, one might reasonably conclude that the courts do not need a Parliamentary reminder.
The proposed preamble states at paragraph (a) that the GAAR applies to deny a tax benefit arising from avoidance transactions that misuse provisions of the Income Tax Act (ITA), the Income Tax Regulations, the Income Tax Application Rules, a tax treaty, or any other enactment that is relevant in computing tax or any other payable or refundable amount, or those provisions read as a whole. This language is followed with the qualifier that taxpayers are allowed to obtain benefits contemplated by relevant provisions. The goal of this paragraph (a) is somewhat unclear: is Finance seeking to reanimate a distinction between misuse and abuse? Further, and as we noted in our Budget commentary, there is a gap: between abusive tax planning and "tax benefits contemplated by the relevant provisions" exists planning that was neither contemplated nor abusive.
Paragraph (b) states that the GAAR: strikes a balance between taxpayers' need for certainty and the government's responsibility to protect the tax base and the fairness of the tax system. There is nothing novel here. The mantra that taxpayers are entitled to "certainty, predictability and fairness" just means that taxpayers should be free from arbitrary determinations by revenue authorities and courts. For a democracy that respects the rule of law and values investment and economic development, "certainty, predictability and fairness" in the application of law is essential. The separation of the concepts of certainty and fairness that appears in the Alta Energy dissent at paragraph 121 (relying on the majority reasons in Lipson) is a distinction that is obvious, but does not affect the actual "certainty, predictability and fairness" principle. At its highest and best, the question of who is entitled to fairness has an easy answer: everyone. But fairness to everyone is not justiciable – at least not in tax, and no GAAR cases have ever (or will ever) be determined based on a standalone fairness argument. The fairness concept in tax disputes is intimately linked to certainty and predictability and, respectfully, the proposed amendment has to be for public consumption rather than for the edification of the courts.
Finally, paragraph (c) asserts that the GAAR can apply regardless of whether a tax strategy is foreseen. This is likely responsive to the statement in the majority reasons in Alta Energy at paragraph 80: "The GAAR was enacted to catch unforeseen tax strategies. However, the use of conduit corporations … was not an unforeseen tax strategy at the time of the Treaty." However, this statement is balanced by the later confirmation that an absence of a SAAR to prevent an outcome is not determinative of whether the GAAR applies but, in the particular case before the Supreme Court, the fact that Parliament could have legislated was a contextual and purposive factor. More to the point, the Supreme Court in Alta Energy concluded that the relevant treaty exemption was a deliberate choice by Parliament. Paragraph (c) may also respond to comments in Lehigh Cement that the Crown cannot discharge its burden to establish misuse/abuse just by asserting that a transaction was unforeseen or exploited an unnoticed legislative gap. That said, comments at paragraph 45 of Deans Knight intimate that while abusive tax avoidance may involve unforeseen tax plans, the GAAR is not limited to that, as it is designed to support the integrity of the tax system by addressing strategies that frustrate the object, spirit and purpose of the relevant provisions.
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The definition of avoidance transaction is proposed to be amended to lower the threshold from a primary purpose test to a "one of the main purposes" test. While the bar would be lower, it would not be entirely non-existent – if tax saving was incidental or "simply a consideration" then a transaction may not be an avoidance transaction. That said, a critic may wonder whether the amendment is necessary.
One of the few or only cases in which the Crown would have benefited from a lower threshold was Spruce Credit, in which no avoidance transaction was found, although the trial judge concluded that the tax benefit may arguably have resulted from a misuse or abuse of the relevant provisions. Changing the law significantly to address a single, unique case may be criticized as excessive. Nonetheless, it could have been worse – there are lower bars (one of the purposes, for example).
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Before critiquing the proposed amendments that would include an economic substance analysis under the GAAR, it may be helpful to put some context around the terminology as well as the history of the GAAR.
First, Canada is a "form over substance" jurisdiction: the legal form of a transaction governs for tax purposes, regardless of the economic outcome. Here's a simple example: a taxpayer with capital invested in a business wants to buy a house. They can get a mortgage and pay non-deductible interest, or pull the capital out of the business to buy the house and recapitalize the business with debt, thus paying deductible interest. They choose the latter. One high-level view is that the taxpayer achieved deductible mortgage interest, an offensive result. Another is that taxpayers can do what they want with their own money and, of course, may optimize their tax position. In any case, while the tax saving goal is clear, and while there is an argument that in substance the taxpayer achieved a deduction for mortgage interest without an overall change in their net worth, the legal formalities of each step in the series are respected and the overall result is irrelevant. However, the general rule remains that legal form trumps economic substance.
Second, the GAAR was enacted in reaction to Stubart Investments, although it has been argued that the GAAR did not reverse Stubart per se. That said, the GAAR's avoidance transaction criterion (a transaction must have been "undertaken or arranged primarily for bona fide purposes other than to obtain the tax benefit") is the broader manifestation of the business purpose test abolished by Stubart. Establishing a statutory transactional purpose test was said to be an appropriate means to interpret the law in accordance with Parliamentary intent, because "most provisions are intended to apply to real economic transactions as opposed to transactions carried out solely for the purpose of obtaining an unintended tax benefit."
Third, the Explanatory Notes to the 1988 legislation that included the GAAR stated that the GAAR:
"Recognizes that the provisions of the Act are intended to apply to transactions with real economic substance, not to transactions intended to exploit, misuse or frustrate the Act to avoid tax. It also recognizes, however, that a number of provisions of the Act either contemplate or encourage transactions that may seem to be primarily tax-motivated. … It is not intended that section 245 will apply to deny the tax benefits that result from these transactions as long as they are carried out within the object and spirit of the provisions of the Act read as a whole."
There is a lot to unpack in the above statement. With respect to "transactions with real economic substance", the argument is that tax law does not subsist in a vacuum but rather sits astride private relationships governed by "general law", so the ITA's provisions speak to transactions entered into for a "real purpose". Flowing from that conclusion is the idea that transactions that are solely engineered to achieve a tax benefit do not accord with the ITA unless they fall within limited circumstances contemplated or expressly encouraged by the ITA. Once again, a criticism is that there is more to tax planning than a relatively crude distinction between transactions with "real economic substance" and abuse. Not every strategy need be blessed by the ITA to withstand a GAAR challenge. Further, Sasseville's 1988 paper went back to Stubart and the Supreme Court's adoption of Drieger's modern rule to confirm that the misuse or abuse analysis in s. 245(4) is an express recognition of that interpretive rule: the GAAR is not meant to apply to transactions, even if tax-driven, if they do not violate the object and spirit of the ITA.
A way to harmonize the commentary from Finance and senior officials may simply be that the GAAR, as originally conceptualized, contemplated "real economic substance" at the avoidance transaction stage as part of reinstituting the business purpose test (writ more broadly as non-tax purpose), while the misuse/abuse stage was meant to be an interpretative rule devoted to determining the object and spirit of the relevant provisions, at which stage economic substance is not integral. If correct, this conclusion challenges the addition of "economic substance" to the misuse/abuse analysis as set out in the proposed amendments.
Finally, the courts have considered economic substance in a GAAR context, most notably the Supreme Court in Canada Trustco:
"Although the expression "economic substance" may be open to different interpretations, this statement recognizes that the provisions of the Act were intended to apply to transactions that were executed within the object, spirit and purpose of the provisions that are relied upon for the tax benefit."
"Although the Explanatory Notes make reference to the expression "economic substance", s. 245(4) does not consider a transaction to result in abusive tax avoidance merely because an economic or commercial purpose is not evident."
Later in its analysis in Canada Trustco, the Supreme Court stated:
While the "economic substance" of the transaction may be relevant at various stages of the analysis, this expression has little meaning in isolation from the proper interpretation of specific provisions of the Act. Any "economic substance" must be considered in relation to the proper interpretation of the specific provisions that are relied upon for the tax benefit.
The Supreme Court's assessment of the role of economic substance in a GAAR analysis was clear: in the Court's view, economic substance is a term that is open to interpretation, may be relevant to interpreting specific ITA provisions, and is not a stand-alone concept. This interpretation is consonant with well-established principles of Canadian income tax: certainty, predictability and fairness; "form over substance"; and the entitlement to order one's affairs to minimize tax. All of these principles would be placed at risk by grafting onto the GAAR a concept, like economic substance, that is open to wide interpretation, and the Supreme Court appropriately put economic substance in its place in Canada Trustco.
Turning to the proposed GAAR amendments, as noted they include an economic substance rule of interpretation for the s. 245(4) misuse/abuse analysis. The proposed language is unusual in fiscal law:
(4.1) If an avoidance transaction is significantly lacking in economic substance, that tends to indicate that the transaction results in a misuse under paragraph (4)(a) or an abuse under paragraph (4)(b) and for these purposes, factors that tend – depending on the particular circumstances – to establish that a transaction or series of transactions is significantly lacking in economic substance include:
(a) All or substantially all of the opportunity for gain or profit and risk of loss of the taxpayer – taken together with those of all non-arm's length taxpayers – remains unchanged, including because of:
(i) A circular flow of funds.
(ii) Offsetting financial positions.
(iii) The timing between steps in the series.
(b) It is reasonable to conclude that, at the time the transaction was entered into, the expected value of the tax benefit exceeded the expected non-tax economic return (which excludes both the tax benefit and any tax advantages connected to another jurisdiction).
(c) It is reasonable to conclude that the entire, or almost entire, purpose for undertaking or arranging the transaction or series was to obtain the tax benefit.
Keywords in the draft stand out. "Tends to indicate" is a concept otherwise unheard of in tax law and that rarely appears in any other statute. The language is obviously cryptic and does not require a judge to find misuse or abuse where there is a lack of economic substance, rather, an assessment of economic substance is only an indicator of potential misuse or abuse. The "tending to" test is repeated with reference to "factors that tend", and if that language was not sufficiently obscure, we are reminded that it all depends on the circumstances. Some indicia are listed, but that list is non-exhaustive as it is prefaced with "includes" – seemingly an invitation to the courts to add their own thoughts about what may tend to have a tendency to indicate something depending on the circumstances.
If a transaction has "economic substance" the usual analysis is followed (determination of the object, spirit and purpose of the subject provisions to localize the policy or rationale, then consideration of whether the transaction(s) frustrated the policy). However if a transaction lacks "economic substance", the same analysis is performed. One wonders how material "economic substance" may be to the usual GAAR analysis. Perhaps it is a tie-breaker. Otherwise, it is strongly arguable that the proposed amendment does nothing more than what was discussed at paragraph 76 of Canada Trustco, referenced above: economic substance may be relevant, but must be considered together with a proper interpretation of specific statutory provisions that were relied on to achieve a tax benefit.
Other challenging wording in the draft includes the reference to "all or substantially all of the opportunity for gain or profit and risk of loss." All or substantially all is typically defined as 90% or more (give or take). However, properly understood "all or substantially all" should refer to an objective or quantifiable concept, like property, supplies, distance, fair market value, or income. Opportunity is neither objective nor quantifiable, regardless of whether it is followed by objective, quantifiable elements like gain or loss.
The confusion is compounded by the phrase "taken together with those of all non-arm's length taxpayers – remains unchanged." Arm's length is a question of fact and, in a complex cross-border structure, determining whether "all or substantially all" of an "opportunity" amongst "all non-arm's length taxpayers" was unchanged is a fiscal Rubik's cube. The puzzle is made all the more complex and multidimensional if economic substance analyses are to be applied to every transaction in a series. One may also argue that economic substance is best considered holistically rather than in the isolation of individual transactions in a series.
Further, insofar as there are factual elements proposed to be included in the economic substance test, one wonders how that impacts on the Crown's usual burden at the misuse/abuse stage of a GAAR analysis. Presumably fact gathering at the audit stage would become even more probing, and the Crown will be granted latitude to make factual assumptions to support its misuse/abuse arguments rooted in economic substance.
Finally, one wonders what judges will ultimately make of the proposed amendments if enacted. It must be presumed that legislative language is meaningful and cannot be disregarded. Thus, judges will have to grapple with economic substance in GAAR cases in some meaningful way, although the weight that may be given to economic substance is an open question. It is unlikely that anyone (including judges) wishes to oust decades of case law, including numerous Supreme Court judgments. Certainly, the usual analysis to locate the underlying policy and determine whether it has been offended will continue to apply. And the courts might form the view that applying the economic substance test as framed is tantamount to trying to nail Jello to a wall because of its vagueness, and that it is unreasonable to graft such a fuzzy concept onto a provision that already subsists at the fringes of the rule of law. But time will tell.
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The proposed amendments include adding a penalty of 25 per cent of the amount of the tax benefit that would have resulted but for the application of the GAAR. A GAAR penalty was apparently proposed when the provision was initially considered, but was never enacted, and the topic has resurfaced from time to time. There are reasonable positions on both sides of the GAAR penalty debate. A naysayer might point out that ITA penalties are typically associated with a failure to do something (like filing) or intentional or grossly negligent non-compliance – and a GAAR-able transaction is fundamentally different because there was compliance with the provisions of the ITA. On the other hand, the disincentive to engage in an abusive transaction is limited to interest on assessed tax and, in this sense, an abusive transaction is at worst a financing deal. However, in my view the penalty proposal should be evaluated in light of the other proposed amendments, like the preamble, the lowered bar for avoidance transactions and, of course, the nebulous economic substance doctrine. If a GAAR penalty was not implemented under "old GAAR", it does not seem fair to create a penalty now, under an amended GAAR that would be both unsettled and significantly more favourable to the Crown.
The penalty may be avoided if the subject transaction is disclosed under the reportable transactions regime in s. 237.3 (as required, or voluntarily). There is no other statutory defense. That said, in Sault Ste. Marie, the Supreme Court recognized three categories of offense, namely, mens rea, strict liability and absolute liability. Under strict liability, doing the prohibited thing attracts a punitive consequence, but defenses lie based on mistaken belief in facts or if reasonable steps were taken to avoid the impugned event. By comparison, there is no defense to an absolute liability offense. Absolute liability is only engaged by express language and mens rea offenses require some degree of intentionality and the elements must be proven by a prosecutor. Otherwise, strict liability may be presumed. Sault Ste. Marie was imported into tax law by Bowman J (as he then was) in Pillar Oilfields as approved of by the Court of Appeal in Consolidated Canadian Contractors. In my view, an implied due diligence defense may be found to the proposed GAAR penalty even if a statutory defense is not enacted. How easy it would be to prove due diligence is an open question: would waiving privilege over an opinion that offers a more-likely-than-not level of assurance work? Would "should" level assurance be required (which might be peculiar, since a "should" level opinion probably "shouldn't" end up in litigation)?
Finally, as Professor Arnold has noted, the quantum of a tax benefit in GAAR appeals is rarely, if ever, an issue. However, if a penalty is to be based on the amount of the benefit, we may reasonably expect more taxpayers to focus on and challenge the determination of reasonable tax consequences that would be denied, per s. 245(5).
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The proposals to amend the GAAR include extending the normal reassessment period by three years to give effect to s. 245, unless the transaction was disclosed under the reportable transactions regime in s. 237.3. The reason for the proposed amendment is that certain transactions that may be GAAR-able are complex and difficult to detect.
Timing for coming into force
Budget 2023 did not specify the effective date for the proposed amendments. Although the government of Canada has previously amended the GAAR with retroactive effect, that step was justified on the basis that the amendments were clarifying (they were not). No such justification exists for retroactive application of the Budget 2023 proposals. However, timing questions remain.
A concern highlighted by The Joint Committee on Taxation of the CBA and CPA Canada in its recent recommendations relates to the "series of transactions" concept. An issue may arise where a series of transactions crosses the effective date of the amendments. The Joint Committee very reasonably asserted that if a series straddles the effective date, then it should not be subject to an amended GAAR. This concern is amplified in light of the potential application of penalties and the unfairness that would result if taxpayers could be penalized for not complying with law at a time when the law was not yet in force.
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Other commentators have observed that the proposed amendments are a solution to a non-existent problem, or predicated on the assumption that if the Crown ever loses a case it must be because of a deficiency in the law, so the law must be changed to ensure the Crown never loses. Without wishing to sound too strident, a critic might say that in other areas of law, contentious cases can go either way, and parties have to live with the results. Further, in the case of Crown litigation, the odds are already stacked, insofar as nobody has deeper pockets or greater patience than the government of Canada which, it has to be noted, makes the laws and also has the largest law firm in the country at its disposal to enforce them.
If a party like a regulator wins every case, one might wonder if they are cherry-picking winners and whether they ought to try more borderline cases. Avoiding cases that could go either way may leave "money on the table", but pursuing such cases comes with litigation risk. A mature view is that this kind of risk comes with the territory.
 David A. Dodge, "A New and More Coherent Approach to Tax Avoidance" (1988) 36:1 Canadian Tax Journal 1-22, at 9.
 The General Anti-Avoidance Rule, Past, Present and Future, Brian Arnold ed., Canadian Tax Foundation, 2010, at p. 23.
 Deans Knight Income Corp. v. Canada, 2023 SCC 16.
 R.S.C., 1985, c. I-21, s. 13.
 Recall that the Explanatory Notes to the 1988 legislation that included the GAAR clearly distinguished between misuse of specific provisions and abuse of the ITA read as a whole (at p. 465). However, the courts have read misuse and abuse together.
 Canada v. Alta Energy Luxembourg SARL, 2021 SCC 49.
 Lipson v. Canada, 2009 SCC 1.
 Lehigh Cement Limited v. Canada, 2010 FCA 124.
 Canadian International Tax Developments, presented at the IFA Canada International Tax Conference, May 16/17, 2023, Calgary, Alberta.
 Canada v. Spruce Credit Union, 2014 FCA 143.
 Some argue that substance may prevail over legal form in certain instances, for example, in the application of s. 84(2) of the ITA.
 Stubart Investments Ltd. v. The Queen,  1 SCR 536.
 Jacques Sasseville, "Implementation of the General Anti-Avoidance Rule" in Income Tax Enforcement, Compliance, and Administration, 1988 Corporate Management Tax Conference (Toronto: Canadian Tax Foundation, 1988), 4:1-16. In fact, at p. 576 of Stubart, the Supreme Court spoke of an interpretive test that would allow the ITA to address the conduct of taxpayers that seeks to defeat the express intention of Parliament – conduct that falls within the object and spirit of the relevant provisions. That interpretive test was the "modern rule" of statutory interpretation. Where Stubart and the GAAR may differ is that Stubart rejected the "business purpose" test as a doctrine that would allow the CRA (or its predecessors) to disregard the tax results of transactions that lack a business purpose independent of tax savings. Although the Sasseville paper disputes this, noting that the Supreme Court stated in Stubart that former s. 245(1) may be applicable where the facts of a case reveal no business purpose, depending on the circumstances.
 Sasseville, supra note 15.
 Dodge paper, supra note 1.
 For example, loss consolidation within a related group is a strategy that may lack "economic substance" while also not being expressly blessed by the ITA. In fact, efforts to enact a group taxation regime have failed. And yet, loss consolidation transactions that comply with the provisions of ITA are not ordinarily GAAR-able.
 Canada Trustco Mortgage Co. v. Canada, 2005 SCC 54.
 Ibid, at paragraphs 56 and 57.
 Ibid, at paragraph 76.
 R. v. Sault Ste. Marie,  2 SCR 1299.
 Pillar Oilfield Projects Ltd. v. The Queen (1993), 2 GTC 1005.
 Canada (Attorney General) v. Consolidated Canadian Contractors Inc. (C.A.),  1 FC 209.
 Brian Arnold, The Arnold Report #256, April 19, 2023.