GAAR and Control – Recent Caselaw
The Supreme Court of Canada’s (the “SCC”) recent news release stated that it will hear the highly anticipated appeal of Dean’s Knight Income Corporation v. His Majesty the King on November 2nd, 2022.
This appeal of the Federal Court of Canada’s (the “FCA”) decision in Canada v Deans Knight Income Corporation, 2021 FCA 160 (CanLII) concerns the interplay between the concepts of ‘control’ within the Income Tax Act (the “ITA”) and the application of the General Ant-Avoidance Rule (the “GAAR”). Specifically, it will likely provide guidance on whether the GAAR’s application can override parliament’s chosen language that indicates whether a “de facto” or “de jure” control standard applies to a particular provision of the ITA and replace it with a different standard, which may result in uncertainty and unpredictability for both taxpayers and tax practitioners.
The SCC stated that the issues in this appeal are as follows:
- whether the FCA erred in relying on the GAAR to conclude that “actual control” was parliament’s intended test under ss. 37(6.1), 111(5) and 127(9.1) of the ITA; and
- whether the FCA erred in concluding, contrary to the trial judge’s findings, that the avoidance transactions resulted in an abuse of ss. 37(6.1), 111(5) and 127(9.1) of the
Key Points on “Control” under the ITA
Prior to the FCA’s Dean’s Knight Decision:
- “De Jure Control”, subject to additional deeming rules, generally considers whether the person(s) or group of persons controlling a corporation hold more than 50% of all issued and outstanding shares or greater than 50% of all issued and outstanding common shares.
- “De Facto Control” or “factual control” considers whether the corporation is controlled, directly or indirectly in any manner by the person(s). It considers whether the potential controller has any direct or indirect influence that, if exercised, would result in control “in fact” of the corporation. Subsection 256(5.11) of the ITA provides that all relevant factors that are to be considered when determining if de facto control exists and is not limited to legally enforceable rights.
Historically, which of these definitions of control applied to a specific provision was solely determined based on the language used by parliament in the relevant provision. Generally, provisions using the word “control” accompanied by “directly” or without attaching any accompanying qualifier meant that parliament intended for de jure to apply as the standard for that provision. Alternatively, words such as “indirectly” signaled parliaments intention for both de jure and de facto control to apply as the standard.
Background of the Appeal
The facts and details of the transactions at issue in Dean’s Knight Income Corporation’s (“Dean’s Knight”) appeal are complex. The following is a simplified background of the events leading up to this appeal.
Prior to the transactions at issue in this appeal, Dean’s Knight was a public corporation operating a drug research and nutrition business that had accumulated approximately $90 million dollars in unused non-capital losses and credits, which were available as carry-forward tax attributes (the “Tax Attributes”).
Dean’s Knight sought to make use of the Tax Attributes by structuring a transaction that in essence would allow it to make these Tax Attributes available to another without triggering an acquisition of control under the ITA that would result in a reset of the Tax Attributes. This event is sometimes referred to as a corporate reset.
To utilize these Tax Attributes and avoid a corporate reset, Dean’s Knight’s entered an agreement with Matco Capital Ltd. (“Matco”) that included the following key terms (among others) and required steps to complete the impugned transaction:
- Matco agreed to invest $3 million dollars using debentures with Dean’s Knight.
- Dean’s Knight formed a new parent corporation (“NewCo”) and reorganize the business and corporation leaving behind only the Tax Attributes of the corporation.
- Dean’s Knight transferred its original business assets to NewCo. In this transfer it transferred the $3 million dollars but left the debentures behind with Dean’s Knight.
- Matco retained the option to acquire a majority of the non-voting shares of Dean’s Knight (approximately 79% of equity shares and 35% of voting shares).
- Matco was required to offer to purchase NewCo’s remaining shares for a minimum of $800 thousand dollars. NewCo retained the ability to reject this offer.
- Matco agreed to arrange for the initial public offering of Dean’s Knight.
- In addition, a nominal amount of shares was issued to a third corporation to avoid the investment agreement becoming a Unanimous Shareholders Agreement.
From 2009 to 2012, after the transaction as completed Dean’s Knight used the Tax Attributes to substantially reduce its tax liability.
History of the Appeal
The CRA reassessed Dean’s Knight’s 2009 to 2012 taxation years and disallowed the non-capital loss deductions associated with the Tax Attributes. As a result, Dean’s Knight appealed to the Tax Court of Canada (the “TCC”).
At the Tax Court, the Minister of National Revenue (the “Minister”) argued that the impugned transactions constituted loss trading and that it was structured to frustrate the purpose of the ITA. The appellant, Dean’s Knight, argued that there was no change of control under the ‘de jure control’ standard, which is necessary to reflect the purpose of parliament.
In the TCC’s decision, Paris J. allowed Dean’s knight’s appeal. The TCC concluded that the GAAR did not apply in these circumstances because although there is a general policy against loss trading within the ITA, it would not be correct to read the provisions as excluding all forms of tax attribute transfers as parliament must have chosen not to refer to de facto control. Consequently, the Minister appealed the TCC’s decision to the FCA.
In the FCA’s decision, it decided to overturn Paris J.’s decision and restore the Minister’s reassessments of the taxpayer. The FCA found that the GAAR did apply to the impugned transaction. Justice Woods, writing for the court, found that the object spirit and purpose of subsection 111(5) of the ITA is to restrict the use of a corporation’s losses to the person(s) who had actual control over its actions and to prevent use of those losses by a new person or persons. Further, the Court found that the TCC judge errored in its decision as the transactions were a circumvention of subsection 111(5) in a way that met the criteria for applying the GAAR pursuant to subsection 11(5) of the ITA.
Dean’s Knight sought leave to appeal to the SCC, and leave was granted on March 10, 2022.
Be sure to check back here at R&A Tax Law for the conclusion of these appeals and a summary of the Supreme Court of Canada’s decision when it is issued.
This article provides information of a general nature only. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions, you should consult a lawyer.