26 November 2023 CTF Conference - "The Future of the GAAR"

This provides summaries of oral remarks provided by Trevor McGowan (Associate Assistant Deputy Minister, Tax Policy Branch, Finance Canada) at the Canadian Tax Foundation annual conference in Montreal on 26 November 2023 in the segment "The Future of the GAAR." The moderators were Carrie Smit (Goodmans) and Shawn D. Porter (Deloitte) whose comments have been substantially reduced to be in the form of questions to Trevor.

GAAR Consultation

The process perhaps began with the last Federal election. The Liberal election platform had a commitment to modernize the GAAR, including introducing an economic substance component. After the Liberals formed the government, that commitment made it into the Minister of Finance’s mandate letter to update the GAAR rule, including an economic substance component, that was announced as part of the 2021 Fall economic statement.

The following summer, the Canadian Tax Foundation put on a symposium on modernizing the GAAR. It and the related book were very useful, and helped to inform Finance’s thinking.

Finance then went through an analytical process in which it initially formulated hypotheses as to what issues there were with the GAAR. Finance worked with its counterparts at the Canada Revenue Agency and the Department of Justice to test these hypotheses. Some of Finance’s hypothesized problems with the GAAR were not borne out in the data, and Finance landed on a few that went forward into the consultation paper.

The consultation paper was released in the summer of 2022, and it was organized into five different sections, each of which started with identifying a problem or issue that Finance was re looking to address as part of the GAAR consultation.

The first one dealt with “tax benefit” and did not propose any specific changes; it was more of a “here are some things we are seeing, but we are not thinking of going ahead with any changes right now”, but the other ones contain proposed changes – with several alternative approaches under each issue. We requested comments about which ideas addressed the problem well, which were problematic, and which were the best. Finance knew at the outset that not all the approaches would be adopted– indeed some were mutually incompatible. Finance also was open to entirely new proposals.

One exception to that general framework was regarding the addition of an economic substance test. This was part of the Department of Finance’s mandate letter, and arose from an election commitment. Because that was baked in, the inquiry was more tightly focused on how to add economic substance to the GAAR, rather than whether to do so.

The basic idea behind the paper was to bring stakeholders in a step earlier than normal in the legislative policy design process. In a number of ways, the consultation was quite successful, and there are certain elements to the GAAR proposals that came out of the process. For example, the preamble was not something that had been included in the paper itself; it had only discussed providing preambles as a method for interpreting other provisions. One of the suggestions received was that it might be helpful, in understanding and applying the GAAR rules, to have a preamble to the GAAR rule itself.

Likewise, the ultimate approach to testing for economic substance that Finance landed on was very much driven by what Finance heard from the consultation, and differed from what had been anticipated at the outset.

Next, in the 2023 Budget, the government released legislative proposals. They were subject to another round of consultation, and that lead to the summer release in 2023 which provided more updated draft legislation proposals for a third round of consultation. The consultation period ended in September, and the government has not released the results of that consultation. The comments on this panel are limited to the version that went out in August.

The consultation process elicited a broad diversity of viewpoints. In addition to comments from the tax practitioner community and taxpayers, comments were received from individuals including great ones from academics, and comments also came in from civil society groups.

The principal components generally were the inserted preamble (to colour the interpretation of the rule more generally), the tweaking of the avoidance transactions threshold from “primary purpose” to “one of the main purposes,” and the addition of the economic substance test and the potential penalty.

The economic substance test first reverses what some would regard as the existing default approach towards dealing with economic substance, arising from Canada Trustco, where a lack of economic substance is generally considered to be irrelevant, unless the provisions otherwise indicate that the transaction is inappropriate. The update reverses that position and indicates that economic substance is relevant, and a significant lack of economic substance is generally significant. Second, the proposals adds a set of rules intended to help provide guidance on what is meant by “lacking economic substance.” From the consultation process, Finance determined that, rather than a single test, it would be better to list relevant factors.

Preamble to the GAAR

What is the effect of the preamble? As noted in the explanatory notes, it tends to inform and colour the actual rules themselves, which are syllogistic – “if A and B then C,” and “if C and D then E.” The preamble is not part of that and, in that sense, it does not fit into the logical flow of the provision. Rather, it is intended to guide how to think about the GAAR. In a lot of GAAR cases, especially at the higher levels, where the court may weigh in on what it thinks is the purpose of the GAAR (why it is there, what it is intended to do) – and the preamble is intended to have a similar effect. It is rather intended to just be in the background and inform the interpretations of the rules.

It is not going to be possible for Parliament, or anyone, to anticipate every possible iteration of transactions that are going to happen that could engage a particular provision that is before Parliament – nor is there a way to tell how every provision is going to interact with every other provision of the Act in some of these transactions.

That said, it is reasonable to expect that Parliament would contemplate the rationale of the rules (as articulated in the Deans Knight): what is the mischief that Parliament intended to address? What types of actions are Parliament trying to encourage by introducing the rule? Those sorts of things are clearly contemplated, and in discussions about Deans Knight – which discusses Parliament thinking about encouraging types of action - is a sense in which Parliament contemplates providing the benefits in certain circumstances, even if it cannot predict every possible iteration where every rule might be engaged.

Significantly Lacking in Economic Substance – The Three Factors

The proposed test for lack of economic substance uses the “and” to join the three factors. Does this imply that all three factors must be present to establish a significant lack of economic substance?

No, all three do not need to be present. Some are more relevant in particular circumstances, so it is not a necessity that all three be present. The “and” is simply for enumerating the factors.

The third factor, the purpose test, is in a sense different from the first two. The first two look more at objective commercial criteria, and the last asks, subjectively or reasonably, what would you think the purpose of the transaction is? It is somewhat more of an abstraction; if there’s smoke there’s fire, there’s an indication that there might be a lack of economic substance based upon the proposition that, if a transaction is entirely tax motivated, then it is it not logically commercial. Conversely, if there is no commercial motivation behind a transaction, that is a pretty good indication that it is probably lacking in commerciality or economic substance.

The test for a lack of economic substance appears to be largely factual. Is that the case?

Yes, they are definitely largely factual, with the caveat that the third is more subjective than questions relating to, for instance, the existence of offsetting financial positions. Whether there is a correlation coefficient between two securities of negative 1, is factual. This should not ought to be coloured at this stage of the analysis by skipping ahead to the conclusion of whether it is a misuse or abuse.

The factors really are asking the question, what is going on here, economically and commercially? To the extent that “what’s really going on” is a novel interpretation of tax rules, perhaps that underscores the need for this sort of rule, although that should not be the case.

One interpretive question is whether one transaction that is part of a series should be looked at in isolation in applying these tests, or whether it is the big picture that should be examined. The basic idea behind the test is to look at what is really commercially going on, and it should be noted that a lot of the factors, particularly in paras. (a) and (b), do not make sense if one transaction is being looked at in isolation. You cannot have a circular flow of funds just looking at one point because the funds have not yet gone around the circle yet. Otherwise, offsetting financial positions would apply only to transactions that can offset each other. The basic idea is to step back and evaluate, holistically, what is really going on commercially.

Does the shifting of onus to the taxpayer change the analysis in any way?

It would be largely the same analysis, but with the presumption that regarding economic substance being generally irrelevant being flipped, so that now it is generally relevant. If a transaction is devoid or almost entirely devoid of economic substance, then that is a factor pointing towards misuse or abuse. But the other factors, such as looking at the rationale of the provision and the context, would be unchanged. Bear in mind, of course, that in cases where the “significantly lacking in economic substance” test is not met, then the changes would have no effect.

Abuse Analysis

Given that Parliament often confers statutory tax benefits in a piecemeal fashion, how would a taxpayer meet this new, elevated standard of persuasiveness in showing that a particular tax arrangement is not abusive?

I do not know that it would necessarily change the standard of persuasiveness, nor am I completely certain about what that precisely means.

If a transaction is significantly lacking in economic substance, that is a factor that tends to point towards a misuse or abuse. The question seems to be premised on the idea that that is where the analysis would stop. But I think that, really, there will be other factors that may point towards it being abusive, such as producing an outcome where, under the scheme of the rules relied upon, a different outcome is clearly contemplated. Conversely, there may be other factors that tend to establish a lack of abuse.

To take an obvious example, if the government were to claim that TFSA benefits were an abuse of the Act, that would render the entire TFSA scheme inoperable.

I do not wish to paint the new changes as entirely inconsequential, but they mainly change how economic substance is dealt with in the analysis.

The “Jane” example in the Explanatory Notes shows Jane extracting cash from her corporation as a capital gain rather than as income. The notes suggest that these transactions do not reflect a shift in the economic position of the group, but is that really an example of a transaction that is significantly lacking in economic substance? The movement of cash here has real-world consequences, as that cash can then, for example, be invested in businesses outside the group. It represents genuine commercial movement.

Moreover, it’s pretty clear that we wouldn’t be talking about a lack of economic substance if Jane had taken the cash out of her company in the form of salary or dividends. It seems more that the determination around economic substance flowed backwards from the preconception that there had been abusive tax-avoidance.

This also raises the question of when Jane is considered to be “in the group.”

Finally, the example doesn’t appear to shed light on how taxpayers can deal with the presumption of abuse.

Can Finance speak to these points?

That example is not a complete example, that stops short of going through the misuse or abuse analysis in respect of that series of transactions. Given the shortness of time, I do not really wish to go through that right now.

To go on to your specific question about whether the economic activity is “genuine,” when you look at the grouping of non-arm’s length entities in a group, the basic concept is of common control. Another central idea, where there is asset within the group – do you actually care where in the group that asset is held? The GAAR would not work if it could be avoided simply by moving such an asset within the group, where the group itself is agnostic as to which entity holds it. It is that structural flexibility that underpins the need for the concept of a “group” in the GAAR.

There are circumstances, e.g., between siblings, where the sale of a business asset from one sibling to another is very much an adversarial situation, and they are very much not indifferent as to who has the money, and how much of it. Those sorts of cases are generally outside the paradigm of non-arm’s -length grouping.

What principles will govern a determination of whether a transaction is significantly lacking in economic substance? Is the test met where in a series of transactions that is economically substantive, one of the steps is itself lacking in economic substance? Examples:

• Use of Bidco in an acquisition transaction to step-up PUC
• Incorporation of a business in order to facilitate a tax cost “bump”
• Incorporation of a business to obtain access to the capital gains exemption
• Exchangeable shares
• Busting s.85.1 with nominal cash

For the many transactions not currently considered (by Finance and CRA) to be subject to the GAAR, will this continue to be the case under the new GAAR?

The exchangeable shares example is a good place to start. Obviously, it is highly fact-dependent, but I think these are well known transactions. Let us assume we’re looking at a “vanilla” exchangeable shares deal that has been around for a while.

So what principles govern it? It is largely factual. It should be looked at holistically, and not just through a particular step. Looking at paragraph (a) (all or substantially all opportunity for profit or risk of loss is unchanged), that phrase is often used in rules such as the securities lending, derivative forward, synthetic equity and synthetic disposition rules, to essentially describe the economics of a transaction. Are the economics unchanged? From the taxpayer’s perspective, a Canco share was exchanged for a share that determines its value off of Forco, and those are economically different things; one tracks the performance of Canco, and the other of Forco, and those values are not perfectly corelated. They are different economic investments and people might prefer to use one over the other. There is no circular cash flow. It is an M&A transaction; previously the taxpayer held Canco shares, and now economically the taxpayer has Forco shares. There is no offsetting of financial positions; again, the taxpayer is fully exposed to the shares received. The timing between steps in the series, that test largely relates to straddle-planning, where there are benefits arising from a rapid succession of transactions – again, that is not happening here.

As for the combination part of the test, that is not necessarily relevant in these cases, like say in the tax shelter or s. 160 planning-type cases. Where the expected value of the tax benefit exceeds the tax return, again, as the opening words suggest, different tests will be more appropriate in different circumstances. Paragraph (a) seems like the one that really gets to the heart of what’s going on here in exchangeable shares, but I would want to note that the deferral benefit can be compared relative to the benefit of having a different type of share, or perhaps of getting a premium on the purchase price or something of that sort.

The paradigm example of the paragraph (b) case would be where you have a package transaction presented and you go in knowing what your economic return is going to be, you know what your tax benefit is going to be, and they are more easily comparable.

Lastly, paragraph (c) looks at the entire purpose for entering into the series of transactions. Presumably, the taxpayer entered into the transactions because it was seen as a good deal. Canco shares are being given up essentially for Forco shares as part of a normal commercial M&A transaction. When you go through these tests, I would suggest that is does not seem to be a transaction lacking in economic substance. It is a real commercial deal where you are giving up something to get something else of economic value despite there being some tax planning involved.

Penalties

The exception to the penalty seems to require a high threshold, which seems inconsistent with the Explanatory Notes, which suggest penalties be avoided where “it would have been reasonable to conclude that a transaction or series would not be subject to the GAAR at the time it was entered into.” The proposed rules themselves use the term “identical or almost identical” to a court case or CRA ruling.

Why is the threshold so high, what does “almost identical" mean, and is there an implicit due diligence defence?

Why is the threshold to the exception to the penalty so high? I think there were concerns that the threshold should not be “vaguely analogous” or something similarly lax. It was set high, and we know that there is a body of cases and rulings, and that planners can make efforts to align with those.

Why no explicit due diligence defense? Again, this was something that came out of the consultation. We were asked and told, and quite reasonably so, I think, that if would be unfair to impose a penalty in circumstances where there was a CRA Ruling directly on point or a case that was directly on point, and they just did what the government had said they could do, and have the penalty apply. That seemed reasonable, so we put it in.

Is the rule intended to encourage taxpayers to report? Yes. That is a full defence to the penalty. If the transactions have been reported, then the penalty simply does not apply, somewhat similar to the Quebec rule where it is more, I think, viewed as a penalty for non-reporting. I do appreciate that that came in at 25% and went up to 50% and then added on a prohibition on government contracts for those considered subject to the GAAR or not reported, but we did 25%.

Finally, Finance confirmed that the standard reassessment period does not generally apply to pre-2024 transactions which may be subject to the GAAR. The intent was that the GAAR would apply to transactions which occur after 2023.

Attendee Questions

What is the meaning of “fairness?”

That relates to the preamble which was added in response to some statements that looked to certainty, predictability and fairness, as if all three words mean the same thing. I will concede that I don’t really know the difference between certainty and predictability – one seems like a subcase of the other – but if you look at the statements that were made contemporaneously when the GAAR was introduced, and which essentially were recorded into the preamble almost word-for-word, “fairness” referred to the fairness of the tax system. So you are weighing certainty on the one hand for taxpayers versus the fairness of the tax system – which is what the GAAR does. It is a balance between the two; one is not paramount. There is not complete certainty all the time, - the GAAR comes in so that a provision cannot be misused or abused. Accordingly, there is a balance, relating to the fairness of the tax system, for example, horizontal equity.

Why weren’t the GAAR changes costed?

I do not believe the government booked any specific revenues for the five-year horizon. That relates partly to the difficulty in predicting specific GAAR revenues. It’s different than if you change the tax rate and you have a predictable increase or decrease in revenues – it’s a lot more lumpy and difficult to predict. And so I do not believe that any specific revenues were booked in the fiscal framework, despite the intent to protect the integrity of the tax base.

Is cash basis accounting dead?

There is a specific rule in the Act which says you are allowed to do cash basis accounting. If the taxpayer makes the decision to do so, there is the question of whether there is a benefit and an avoidance transaction. However, I would have thought that if the taxpayer is doing precisely what the election to use cash basis accounting rules is intended to let you do, then it is hard to see how one would be frustrating the object, spirit, and purpose, or rationale, of those rules.