By Jamie Golombek
This month, the Supreme Court of Canada is scheduled to hear its first ever general anti-avoidance rule (GAAR) cases - Eugene Kaulius, et al. V. Her Majesty the Queen and Her Majesty the Queen v. Canada Trustco Mortgage Company. These two cases come 17 years after the GAAR was first introduced. Yet, despite numerous scholarly articles, seminar presentations and discussions relating to the GAAR, it still remains one of the more ominous, elusive and mysterious pieces of tax legislation in the entire Act.
Jamie Golombek explains what GAAR is, how it works and what financial planning strategies may be at risk.
Many brilliant tax schemes, some of them involving complex estate and life insurance planning, have been recommended to clients, but always with the seminal warning that "the GAAR may apply". But what is GAAR? The definition is neatly contained within a few pages of the Income Tax Act. The main rule is contained in subsection 245(2), which states that if a transaction is classified as an "avoidance transaction", the Act will deny any tax benefit resulting from that transaction. What, then, is an avoidance transaction?
An "avoidance transaction" is defined as a transaction (or part of a series of transactions) where the transaction (or the series) results in a "tax benefit", unless the transaction is carried out primarily for bona fide, non-tax purposes. A "tax benefit" includes a reduction, avoidance or deferral of tax.
Subsection 245(4) of the Act states that the GAAR will not apply to a transaction as long as the transaction does not result in the "misuse" of a provision of the Act or an "abuse having regard to the provisions of the Act read as a whole".
The GAAR committee
Coincident with the introduction of the GAAR in 1988, the Canada Revenue Agency (CRA) established a committee (the "GAAR committee") in Ottawa to deal with specific questions regarding the potential application of the GAAR stemming from audits being conducted or reassessments being proposed across the country.
The GAAR committee, currently chaired by Wayne Adams, the director general, Income Tax Rulings Directorate at the CRA, is composed of senior members of the CRA as well as members from the Department of Justice and the Department of Finance.
How does a case get to the GAAR committee? Most of the GAAR referrals come from CRA auditors who stumble across what they might first perceive to be an avoidance transaction during the course of an audit. To this end, the CRA provides auditors with GAAR training courses in order to assist them in identifying tax-avoidance issues.
If an auditor identifies a transaction that she feels may be an avoidance transaction in which the GAAR might apply, the auditor first consults with the Tax Avoidance section of her local CRA Tax Services Office (TSO). The local Tax Avoidance section will review the transaction, but before any GAAR reassessment can be issued, the TSO will generally refer the case to CRA headquarters in Ottawa.
At headquarters, the case is again reviewed to determine whether or not they agree with the recommendation to apply the GAAR. If they decide that the GAAR does not apply, the case need not be referred to the GAAR committee. If, on the other hand, headquarters agrees with the TSO's recommendation to reassess the taxpayer using the GAAR, input will be sought from the GAAR committee before proceeding with any GAAR reassessment.
The GAAR committee is scheduled to meet every other week, assuming there is a full agenda, which typically consists of three or four GAAR cases to be reviewed. At the meeting, the auditor from Tax Avoidance will present the facts and recommendations to the committee for review. The committee will then recommend whether or not GAAR should be applied to that particular transaction.
The committee's decision is then relayed back to the Tax Avoidance section, which will forward the decision to the auditor. Interestingly, the auditor is not legally bound by the decision of the GAAR committee, but it is highly unlikely she would apply the GAAR where its application was not recommended by the committee. On the other hand, if the committee has recommended that the GAAR apply, it is possible that the auditor may decide not to proceed in reassessing the taxpayer, perhaps as part of a larger settlement.
The stats
Since the introduction of the GAAR in 1988 through October 2004, there have only been 620 cases reviewed by the GAAR committee, covering a variety of tax issues. Of those cases, the GAAR was recommended to be applied in 385 cases and was found not applicable in the remaining 235 situations.
What's more surprising is that to date, there have only been about 23 GAAR cases that have made their way to court. Most of these cases have been at the lower court level (i.e., the Tax Court of Canada or the Federal Court - Trial Division), but eight of them have reached the Federal Court of Appeal, of which Kaulius and Canada Trustco are currently before the Supreme Court.
How has the CRA fared in these 23 GAAR cases? Not well. The CRA has been successful in applying GAAR only eight times, of which only three were at the Federal Court of Appeal level. The decisions regarding the two recent GAAR cases (Eugene Kaulius, et al. v. Her Majesty the Queen and Her Majesty the Queen v. Canada Trustco Mortgage Company) will be released by the SCC later this year, which should provide us with even more guidance as to how successful the CRA may be in trying future GAAR cases.
Could the GAAR apply?
Let's take a closer look at a tax planning idea that has been circulating through the financial planning industry in recent years to see if the GAAR may apply.
Jack and Jill, your clients, are husband and wife. Jack is a high income earner and is in the top bracket of 45 per cent while Jill is in the lowest bracket, say 25 per cent. Jack owns 10,000 insurance company shares with a fair market value (FMV) of $100,000 that he received through an insurance demutualization. As a result, the adjusted cost base (ACB) of the shares is zero. Jack is contemplating selling his shares and has approached you in an attempt to try to reduce the tax payable on the sale.
If Jack were to sell the shares outright, his proceeds would be $100,000, his ACB zero and thus his tax payable $22,500 (being 50 per cent of the capital gain of $100,000, taxed at his marginal tax rate of 45 per cent). Rather than have Jack pay this much in tax, we're going to come up with a plan.
First, Jack will transfer half of his shares to his wife, Jill, for zero proceeds. The capital gain on the transfer is zero because the shares being transferred roll over to Jill at their ACB. The ACB to Jill, therefore, is also zero. Because the transfer was done at ACB, any capital gain on the ultimate sale of the shares would be attributable and taxable back to Jack since Jill did not pay FMV for the shares.
Jack will then sell the other half of the shares to Jill at FMV in exchange for a $50,000 interest-bearing promissory note. Since the ACB is zero, the capital gain to Jack is $50,000, resulting in a tax bill to Jack of $11,250 ($50,000 capital gain X 50% X 45%). Because the transfer is taking place at fair market value, attribution will not apply on the ultimate capital gain resulting from the later disposition of those shares by Jill.
Finally, Jill disposes of all of the shares - the half she received as a gift and the half she purchased at FMV from Jack. Assuming no further market fluctuations, she will receive proceeds of $100,000. Under the identical property averaging rules in the Income Tax Act, Jill's cost base of the shares is a total of $50,000 _ being the total ACB of the gifted shares ($0) and the purchased shares ($50,000). Since her proceeds are $100,000 and her ACB $50,000, her capital gain is $50,000. Only half of it, however, is taxable to Jill and the other half is attributable back to Jack because only half of the shares were transferred at cost - the other half were transferred at FMV and, therefore, the attribution rule does not apply to those shares.
The tax on the ultimate $50,000 capital gain would be split in two - tax payable by Jack of $5,625 ($50,000 / 2 x 50% x 45%) and tax payable by Jill of $3,125 ($50,000 / 2 x 50% x 25%), for a total tax bill of $8,750.
To summarize, if you did no planning, Jack would have paid $22,500 tax on the $100,000 capital gain. If instead you implement the plan above, Jack's tax from the transfer of half the shares at fair value is $11,250, Jill's tax is only $3,125 and Jack's tax on the gain attributed back to him is $5,625. So, in fact, the total tax liability is only $20,000, which would represent a tax savings of $2,500.
So, would the GAAR apply to this transaction? Well, we may soon find out as a similar type of plan involving significantly larger amounts is currently before the Tax Court of Canada in a case to be heard in Montreal (Berman 2001-4131(IT)G).
In Berman, the CRA is claiming that the GAAR is indeed applicable in a similar fact pattern to that of Jack and Jill and that the entire capital gain should be taxed in the transferor's hands. According to the CRA, the transfer of the shares and the subsequent sale of those shares constitute an avoidance transaction that was carried out primarily to obtain a tax benefit. But was it a misuse of the identical property averaging rule? Was it an abuse of the purpose of the attribution rules?
According to Ken Skingle, a tax partner at Calgary law firm Felesky Flynn LLP who wrote a paper on the GAAR last year that specifically discussed the upcoming Berman appeal, " ... if Parliament had considered it desirable to isolate the cost of properties, which are subject to the attribution rules following a transfer between spouses, it certainly was open to exempt such properties from the ... cost averaging rule".
In fact, Parliament did exempt certain securities acquired upon exercise of employee stock options from the cost averaging rule by deeming them not to be identical properties to other securities owned by the holder. Surely Parliament could have done the same with respect to transfers of shares between spouses.
Skingle concludes that the CRA "will have an uphill battle in establishing that the transactions ... constituted a misuse or abuse of any of the provisions of the Act. To the contrary, the better view is that those transactions fall squarely within the "clear and unambiguous' policy regarding allowable tax-deferred transfers".
GAAR and insurance strategies
Finally, a couple of comments are warranted regarding the potential applicability of the GAAR to various sophisticated insurance tax-planning strategies currently being recommended by advisors. For example, some commentators have suggested that the GAAR may apply to leveraged life insurance programs whereby the client purchases an exempt policy (typically universal life), makes deposits for several years (which grow tax-deferred) and, upon retirement, borrows money from a financial institution using the life insurance policy as collateral for the loan. The GAAR issue is that the CRA may attempt to recharacterize the third-party collateral loan as a policy loan, the consequence being a disposition of the policy, which could result in a taxable policy gain.
While a complete analysis of the applicability of the GAAR to these types of insurance strategies is beyond the scope of this article, interested advisors are urged to refer to Joel Cuperfain and Florence Marino's excellent reference book, Canadian Taxation of Life Insurance (Carswell 2004), which presents a detailed GAAR analysis of various life insurance strategies.