GAAR me maties. Prepare to be audited!
Part I of this series on GAAR introduced GAAR as part of an indicator of the complexity of our tax system. As a reminder, GAAR is about perceived misuses or abuse of the tax system. I use the word perceived because it is all about someone using the provisions of the tax law but doing so in what CRA determines is an abusive manner.
GAAR has been one of the key drivers of tax litigation in Canada in recent years. All proposed assessments that invoke GAAR must be reviewed first by the GAAR committee. The GAAR committee is comprised of members of the Income Tax Ruling, Legislative Policy, and Tax Avoidance units at CRA as well as tax lawyers and members of the Tax Policy Division at the Department of Finance. In 2011-2012, 83 new cases were referred to the committee, which concluded that GAAR applied to a whopping 80 (96%) of those cases. Over its lifetime, the Committee has reviewed nearly 1100 cases with a ‘success’ rate (those cases they decided that GAAR did apply) of 76%. The increase in the success rate in recent years could be due to the Committee being more aggressive with GAAR’s application, CRA being better at deciding when GAAR should apply, or tax payers becoming more aggressive with tax avoidance maneuvers. I think it is more likely a combination of all three of these.
According to this report by KPMG, the biggest incidence of GAAR cases involve surplus or dividend stripping. Surplus stripping is a long used method of extracting retained earnings and profits from a corporation other than in the form of dividends. The Canadian Tax Journal has an excellent article on this method for those interested in more information.
This is followed closely by loss creation via a stock dividend. This technique is well discussed in this paper by McCarthy Tetrault. The very short summary of this is that A Co creates B Co. Then A Co transfers assets into B Co in exchange for divided paying shares. B Co then sells those assets and with the proceeds pays a dividend to A Co. A Co then sells B Co to someone else for a capital loss. A Co not only gets the dividend but also a tax loss for having sold something for a loss.
The third most common application of GAAR is the kiddie tax. This was a very popular way to income split in the 1990s but not so much now, since section 120.4 of the ITA was added which closed this ‘loophole’. In this scheme, a business owner issues dividend paying shares to his/her children. Since the children have little or no income and can use their basic personal and dividend tax credits , the dividends are essentially tax free. The dividend stream would then be used to pay for the kids expenses (like private school).
Despite these crackdowns, there is still some skepticism with GAAR. GAAR is great at cracking down on these known loopholes, but what it is not good at is seeing these ‘loopholes’ before they become well known. That is, it takes years for new and novel abusive tax schemes to get on CRAs radar and even more years before moving onto GAARs radar. The more you are operating on the cutting edge of tax avoidance, the more likely you will get away with it.