Deans Knight: The Case For Rethinking GAAR Amendments

• Published date: 07 June 2023
• Subject Matter: Corporate/Commercial Law, Tax, M&A/Private Equity, Corporate and Company Law, Directors and Officers, Income Tax, Shareholders
• Law Firm: Borden Ladner Gervais LLP
• Author: Ms Laurie A. Goldbach, Elizabeth Egberts and Steve Suarez

By Steve Suarez, Laurie Goldbach & Elizabeth Egberts, BLG¹

On May 26, 2023, the Supreme Court of Canada (SCC or the Court) dismissed the taxpayer's appeal in Deans Knight Income Corp. v Canada, 2023 SCC 16 (Deans Knight). This much-anticipated decision deals with the general anti-avoidance rule (GAAR) in section 245 of the Income Tax Act² (Act). Where applicable, GAAR allows the Canada Revenue Agency (CRA) to redetermine the tax consequences of a transaction. For GAAR to apply, the taxpayer must have engaged in a transaction or series of transactions with the primary purpose of obtaining a tax benefit, in such a manner as to result in an abuse or misuse of one or more provisions of the Act. To date, relevant jurisprudence has established that a two-stage GAAR analysis be employed to determine whether a transaction is abusive. First, the court determines the object, spirit and purpose (OSP) or legislative rationale of the relevant provisions of the Act. Second, the court decides whether a specific transaction has frustrated or abused that OSP or legislative rationale.

Deans Knight considered the potential application of GAAR to transactions specifically designed to avoid triggering s. 111(5) and related provisions (collectively referred to herein as the corporate loss restrictions), which restrict a corporation that has undergone an "acquisition of control" (AOC) from using its pre-AOC accumulated business losses in post-AOC taxation years.³ These rules interpret "control" as de jure control: the ownership or control over the voting rights of such a number of the corporation's shares as would entitle the owner/controller to elect a majority of the corporation's board of directors.⁴ The taxpayer in Deans Knight had been a public corporation that accumulated $90 million of business losses,⁵ which it sought to monetize via a series of transactions carefully designed to avoid creating a de jure AOC, thus preserving its ability to utilize those losses.

Key takeaways

In a 7-1 decision, the Supreme Court ruled that the taxpayer had contravened the legislative rationale of the corporate loss restriction regime, because an unrelated third party had acquired the "functional equivalent" of de jure control, in this case by means of contractual arrangements that would not (outside of GAAR) be relevant in determining de jure control. In so ruling, the Court established the de jure control standard as the threshold inherent in the OSP of the corporate loss restriction rules and, critically, rejected the use of a lower threshold of 'actual control' or 'effective control' as suggested by the lower courts and the Crown. Justice C'té in dissent, opined that the majority's introduction of "functional equivalence" ignores the 'radically different' ways these share voting rights and contractual agreements are enforced and results in the Court overriding Parliament's clear intent and articulation of a de jure control test.

Deans Knight represents an endorsement of the continued application of long-established legal principles and a refinement of the approach to GAAR analysis without disturbing prior GAAR jurisprudence. As such, Deans Knight does not significantly change the legal framework of GAAR, as the Court's reasoning is rightfully tethered to the de jure standard used in the corporate loss restriction rules and does not establish new legal principles, and the result of the case itself is largely fact-specific. From a practical perspective however, Deans Knight illustrates that if a taxpayer achieves an outcome highly similar to (or in this case, found to be "functionally equivalent" of) that at which a particular provision is directed, there is a very significant risk that it will be found to have come within the legislative rationale of that provision with the result that GAAR applies.

Deans Knight shows that courts are not hesitant to apply GAAR in a flexible and broad way to prevent outcomes they perceive to be contrary to Parliament's intent. To the extent any justification previously existed for the government's proposed legislative amendments to GAAR announced in the federal budget of March 28, 2023, Deans Knight decisively negates it. The existing GAAR jurisprudence, endorsed and refined by Deans Knight, is already performing the very functions that these legislative amendments to GAAR relating to abuse and misuse purport to address. We invite the government to rethink its proposed GAAR reform, following this clear indication from the Court.

Facts

The taxpayer, Deans Knight, began as a publicly-listed drug research and food additives company that experienced financial difficulty and underwent a reorganization under which it became a wholly-owned subsidiary of a new widely-held and publicly-traded corporation (NewCo). NewCo and Deans Knight entered into an agreement (the Investment Agreement) with an unrelated third party (Matco) under which:

• in exchange for $3 million, Deans Knight issued a debenture to Matco convertible into 35 per cent of its voting shares plus non-voting shares that collectively represented 79 per cent of Deans Knight's equity;
• Deans Knight 's business and the $3 million were transferred to NewCo, effectively leaving Deans Knight "a shell with no assets and one liability: an obligation to pay principal and interest to Matco under the convertible debenture";⁶ and
• Matco agreed to use its expertise to arrange a corporate opportunity for Deans Knight whereby new funds would be raised in an initial public offering so as to avoid triggering an acquisition of de jure control of Deans Knight under s. 111(5), such funds to be used to establish a business whose income would be sheltered by Deans Knight's tax losses; and
• Matco was obligated within a year to pay another $800,000 to NewCo (either to acquire NewCo's Deans Knight shares or otherwise).

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Eventually, Matco arranged a $100 million IPO of Deans Knight under which the money raised would be managed by Deans Knight Capital Management Ltd. and used to earn income from corporate debt securities, which was sheltered from tax using Deans Knight 's accumulated $90 million of tax losses and similar deductions and credits from 2009-2012. Matco exercised its conversion right to convert the Deans Knight 's debenture into voting and non-voting shares and purchased NewCo's shares of Deans Knight for the agreed $800,000. The result was that NewCo received a total of $3.8 million for the Deans Knight shares, and Matco's publicly-traded Deans Knight shares following the IPO were worth $5 million.

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The Lower Court decisions

Tax Court of Canada

In considering the application of the GAAR, the Tax Court of Canada (TCC) found the first stage of the GAAR test was met, such that the taxpayer derived a tax benefit from the transactions at issue. On the second stage of the GAAR test, the TCC found that the primary purpose of the transactions was to "monetize" the taxpayer's tax attributes, creating an "avoidance transaction". In determining the relevant OSP of the relevant provisions, the TCC held that:⁷

• the OSP of paragraph 111(1)(a) (which allows a taxpayer to use business losses from one year against income in a later year) is "to provide relief to taxpayers who have suffered losses given that the government, through income tax, shares in the income of a taxpayer";
• the OSP of subsection 111(5) is "to target manipulation of losses of a corporation by a new person or group of persons through effective control over the corporation's actions" and
• the OSP of paragraph 256(8) is "to prevent a taxpayer from circumventing the listed avoidance provisions by acquiring control over shares or share voting rights in order to achieve effective control of the corporation".

In applying these legislative rationales, the TCC found that the tax benefit achieved was not abusive, largely because in the TCC's view "Matco simply did not have effective control over [Deans Knight] or need such control to make the arrangement work".⁸

Federal Court of Appeal

The Crown appealed the TCC's decision to the Federal Court of Appeal (FCA). In a unanimous ruling, the FCA concluded that the transactions at issue constituted an abuse of s. 111(5), thereby causing GAAR to apply such that the taxpayer's use of its accumulated pre-AOC losses was restricted by the rules in the corporate loss restriction regime.

The FCA agreed with TCC's view that the OSP of subsection 111(5) is "to target manipulation of losses of a corporation by a new person or group of persons, through effective control over the corporation's actions". However, to add clarity to the concept of "effective control", FCA reformulated the OSP of these provisions as follows:

[72] However, the Tax Court's statement of the underlying rationale of subsection 111(5) lacks clarity. This was evident in the submissions before this Court on what the Tax Court meant by "effective control". I would rearticulate the object, spirit and purpose of subsection 111(5) as follows: it is to restrict the use of specified losses, including non-capital losses, if a person or group of persons has acquired actual control over the corporation's actions, whether by way of de jure control or otherwise.

. . .

[93] For these reasons, I conclude that the object, spirit and purpose of subsection 111(5) is, at least in part, to restrict the use of specified losses, including non-capital losses, if a person or group of persons has acquired actual control over the corporation's actions, whether by way of de jure control or otherwise.

The FCA further clarified that the TCC did not mean "effective control" to be a synonym for de jure control, and introduced "actual control" as a replacement term ostensibly to avoid confusion.⁹ In so doing, the FCA effectively created a new AOC standard inherent in the legislative rationale of s. 111(5), stating as follows:

[83] It is true that the object, spirit and purpose of subsection 111(5) as articulated above does include forms of...