Comment on Copthorne Holdings Limited V. The Queen

In a unanimous decision rendered by Justice Rothstein, the Supreme Court of Canada today dismissed the appeal of Copthorne Holdings Limited, applying the General Anti Avoidance Rule (“GAAR”). While confirming the result reached in this case by the Tax Court of Canada and the Federal Court of Appeal, the Supreme Court provided further systematic analysis of the application of the GAAR.   The three elements required for an application of the GAAR to nullify the tax effect of a series of transactions that meets the specific requirements of the Income Tax Act (the “Act”) are:   1. The existence of a “tax benefit”; 2. An “avoidance transaction”, being a transaction, or one in a series of transactions, that was entered into primarily to obtain a “tax benefit”; and 3. “Abuse” of the Act or of any its provisions.   To simplify the factual background, a non-resident parent corporation: (A) invested some $96,000,000 in the shares of a Canadian subsidiary (B), which, under the Act, became the paid-up capital (PUC) of those shares. B in turn invested some $67,000,000 of that amount in the shares of its Canadian subsidiary (C), which would be the paid-up capital of C’s shares.   The amount of a corporation’s PUC is important for tax purposes because, for example, on redemption of its shares a dividend, giving rise to potential tax, is only deemed to occur to the extent that the redemption proceeds exceed the PUC of the redeemed shares. If B and C had amalgamated at a time when they were parent and subsidiary, under the Act C’s PUC would disappear, and the PUC of the amalgamated company would be $96,000,000.   In 1993-94, the result of a number of transactions was that B sold its shares of C (which had declined in value) to A. Consequently the PUC of the shares of B and of C remained unchanged. In response to certain proposed tax changes, B and C were amalgamated in 1995. Under the Act (apart from the GAAR) the amalgamation would preserve the PUCs of both B and C, resulting in a PUC of some $163,000,000 in the shares of the amalgamated corporation. These shares could then be redeemed for up to that amount without causing a deemed dividend. The shares in fact were redeemed in the hands of A in 1995, and the taxpayers took the position that there was no deemed dividend because of the high PUC of the redeemed shares. Invoking the GAAR, the Canada Revenue Agency reduced the PUC of the amalgamated company by $67,000,000 and imposed withholding tax of some $8,000,000 on the resulting deemed dividend to a non-resident shareholder.   In agreeing with the lower courts that there was a “tax benefit”, the Supreme Court of Canada analysed what would have been done if there had been no tax advantage in making B and C sister corporations instead of amalgamating them while they were parent and subsidiary. The “tax benefit” from making them sister corporations was to add some $67,000,000 to the PUC that otherwise would have disappeared.   The Court affirmed that, if any transaction that is part of a series of transactions “is not undertaken primarily for a bona fide non-tax purpose that transaction will be an avoidance transaction”. The redemption was such a transaction, and the remaining question was whether it was part of the same series as the earlier transactions that had made B and C sister corporations. The provisions of the Act deeming “related transactions or events completed in contemplating of” a series of transactions to be part of the series were applied, on the basis that “contemplation” can occur after, as well as before, the “related transactions or events”. Here the redemptions occurred with full knowledge of the earlier restructuring, making all these transactions part of the same series, so that there was a “avoidance transaction”.   Unfortunately this approach to determining when there is a series leaves the matter very indefinite. It might be argued that, whenever a transaction occurs that takes into account a previous transaction, no matter how remote in time, the necessary “contemplation” would be present, making the earlier and later transactions part of the same series. The Court tried to back away from this result by suggesting that the elapse of time may be relevant, but how or why is not made clear. It is regrettable that this uncertainty remains.   A large part of the decision concentrated on whether there was an “abuse”, which the Supreme Court of Canada in its 2005 decision in Canada Trust Co. had held must be proved by the Crown. The Court noted that “because of the potential to affect so many transactions, the court must approach a GAAR decision cautiously.” Nevertheless it concluded that there was abuse here, in that the $67,000,000 PUC of C, which had arisen because of an investment by B of part of the amount that had gone into B’s PUC, had been duplicated, contrary to the clear policy in the Act, as illustrated in the rules that eliminate the PUC of a subsidiary corporation when it amalgamates with its parent.   The Court noted that “whether a transaction is abusive will only become apparent when it is considered in the context of the series of which it is a part and the overall result that is achieved”. Here, consequently, the Court is looking at the series as a whole and not, as when it is looking for an “avoidance transaction”, at the individual components of the series. It concluded “that the intent is that PUC be limited such that it is not inappropriately increased merely through the device of an amalgamation”; the “object, spirit and purpose” of the amalgamation provisions of the Act were “to preclude the preservation of PUC, upon amalgamation, where such preservation will allow a shareholder, on a redemption of shares by the amalgamated corporation, to be paid amounts without liability for tax in excess of the investment of tax-paid funds”.   In the end, the result of the decision is not surprising, but its analysis will require careful attention. As indicated earlier, it does leave interpretation problems regarding the meaning of “series of transactions”, and the uncertainties of when a series is to be regarded as “abusive” inevitably remain.   For more information regarding this Tax Brief, please contact Edwin Harris, QC, FCA.   McInnes Cooper’s newsletters are prepared for information only and are not intended to be either a complete description of any issue or the opinion of our firm. McInnes Cooper should be consulted regarding any situation to which any topic discussed herein might apply.