Corporate tax avoidance, tax evasion, and GAAR: Oh my!

There has been a lot of attention on corporate tax avoidance of late, with calls for corporations to ‘pay their fair share.’ If you are in this camp, then I hope you are following closely the OECD BEPS debates, the luxleaks fall out, and yes even the federal budgets. No? Well, then you should.

A lot of people seem to equate corporate tax minimization strategies with tax evasion. But rarely are their shenanigans cut and dry evasion. Most of corporate tax strategies used to minimize their taxes use the existing tax code to their benefit (as we all are allowed to do). This is why a lot of focus in the last few federal budgets has been focused on closing loopholes that allow some of this behavior. One area of focus has been to stop relying so much on the General Anti-Avoidance Rule (GAAR, I blogged about GAAR before, here and here) and instead detail specific anti-avoidance rules. However these specific rules don’t seem to get much attention outside of very small tax nerd circles. But this move I think is important for all of us to understand.

So let me talk about the surprise element in Budget 2015 that did not get much attention at the time of the budget (or even now) outside of narrow tax circles, but it was an interesting one and caught many off guard. Budget 2015 included specific anti-avoidance rules for synthetic equity arrangements (SEA).

As you know (?), some shares in Canadian companies pay dividends. Dividend income is taxable (sort of), but there are very special rules when a Canadian company pays a dividend to a Canadian resident for tax purposes. On the corporate side of things, when a dividend is received by a Canadian corporation from another Canadian corporation, the receiving corporation is permitted to deduct these dividends when computing its taxable income to avoid double taxation of the dividend income. This is because the dividend is paid out of after tax income.

There are, however, caveats to this rule. The receiving corporation is not eligible for the deduction if the dividend is received as part of a dividend rental arrangement (DRA). A DRA is when a Canadian company enters into an arrangement that enable the Canadian company to receive a dividend on a share, while economic exposure to the share accrues to, or is borne by, someone else, usually a non-Canadian company who wanted the shares, but because they are not a Canadian company, can’t deduct the dividend. That is, the whole point of these types of DR arrangements is essentially tax avoidance and run against the spirit of the tax principles embodied in the Income Tax Act.

Unfortunately, there are a lot of people paid a lot of money to find new and wonderful ways around these types of tax rules and that is indeed what happened. As a result, Budget 2015 extended the definition of DRAs to include a new and specific form of these arrangements called synthetic equity arrangements. SEAs potentially avoided the application of the DRA rules, mostly because they were so convoluted that it was not clear what these arrangements were. SEAs appeared to be mostly used in the financial sector and were generally unknown to a lot of people. The fact that Finance caught wind of these things, understood them, and cracked down on them is a testament to their catch up abilities. However there were a lot of people on the tax community that were highly skeptical that this crack down would result in the increased revenues detailed in the Budget, which seemed oddly calculated to ensure a budget surplus.

However, by the sounds of it, these transactions were already caught under the existing DRA or GAAR, but given that Finance devised specific rules for these arrangements (and actually any future arrangements that look like SEAs, but were designed to get around these new rules), it is very clear that (1) Finance wants to signal to the corporate community that these kinds of tax shenanigans will not be tolerated and (2) was hesitant to get involved in any more lengthy and complex GAAR cases.

Given that this is the second budget that opted for such complex specific anti-avoidance rules (Budget 2013 had a similar approach to character conversion transactions and synthetic dispositions), some are wondering if the GAAR will become a thing of the past signaling increasing complexity of our tax code. I mean, Ottawa is still consulting on the latest anti-avoidance rules and I expect it will be not until 2016 that we see anything specific tabled.

And of course these specific anti-avoidance rules only target the stuff we already know about. I assure you that hours after the budget was announced, a bunch of highly paid folk began huddling around their desks/computers/tablets/smartboards creating the next thing to minimize taxes using the letter of the law. I bet that they have completed their work and we will be hearing about the next specific anti-avoidance rules in short order.

That is the tricky part with combating tax noncompliance. You are always a few steps behind those whose job it is to find ways around the rules. So for those of you who seem to think CRA should just crack down and close the loopholes, it is a lot harder than it sounds. Crack down on what? Where? How? What loopholes? Those loopholes that allow preferential tax treatment for you too?

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4 thoughts on “Corporate tax avoidance, tax evasion, and GAAR: Oh my!

  1. Isn’t the whole reason for GAAR to avoid having to play whack-a-mole with tax avoidance strategies? In principal, it should make this whole industry of looking for loopholes and obscure transaction structures illegal, akin to the people who facilitate money laundering. Maybe the enforcement structure is just too cumbersome. But if it’s not doing its job well enough, it seems that a broad principle-based rule to replace it would be better than trying to hit every single loophole.

    Seems more likely that the specific rules are there because they provide an announceable. Something the politicians can point to and say “Hey, we did something today.” It’s just the mirror image of boutique credits. And, as you suggest, they can assign a convenient revenue estimate to their announceable to cleanly balance the budget.

    • It is possible that the GAAR structure (rather than the existence of GAAR itself) is just overly clunky and lengthy. Though Finance has shows a penchant for specific anti-avoidance rules with the 2000 creation of 120.4 of the ITA (i.e. the kiddie tax) and its revision in Budget 2014 along with the corporate ones in 2013 and 2015. Musings seem to suggest that Finance moves on specific anti-avoidance rules to clearly signal to the tax community to stop it, rather than wait for a GAAR case to wind its way through they system.

      On the corporate side, I have to wonder if more and more specific rules are due to the public appetite to see corporate evasion stopped in its tracks. So, yes, the appearance of doing something that was already being done. It is hard not to be overly cynical.

  2. Nice post. I enjoy your twitter feed. Two points —
    1. Not only is the pre -2015 AB tax not regressive — it is progressive. It should not be called a flat tax — it should be called a “one rate” tax. The high exemption limit ( 17K ) means that at about 35K of income it is 5% tax from dollar zero and 7.5% tax at 70K income and so on. Granted the line flattens out at very large incomes — the fact is for 95% of actual real world income ranges it has always been progressive. You can debate the angle of the curve but it is progressive factually.
    2. I think your graphs should reflect point 1 above. While the graph that shows a flat 10% after the personal exemption amount on the zero line is correct if you call the Y axis “marginal tax ” it would be better in comparison to other provinces if you graphed the actual tax rate at various incomes and it would show an Incline line simular to other provinces. ( for most incomes )
    John Lawson
    Calgary

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