On the evening of March 6, 2018, I was fortunate enough to be in Victoria and invited by Murray Rankin, the MP for Victoria, to participate in a community town hall he was hosting on his private member’s bill to add an economic substance test to section 245 of the Income Tax Act (ITA).
Section 245 of the section of the ITA is the General Anti-Avoidance Rule. In the early days of this blog, I had two posts about Canada’s General Anti-avoidance Rule (GAAR). One was on the basics of GAAR and the other was on some of the ways GAAR has been used. What I am going to do here is walk us through why we should be supporting Murray’s bill.
“Modern” Canadian tax avoidance law was established in the UK in 1936 which legitimized legal tax avoidance. This was the Duke of Westminster case that established that taxpayers are entitled to structure their affairs to minimize their tax liability and they cannot be compelled to pay an increased tax. This ruling features prominently in the Canadian tax system and is the key principle governing tax law.
Of course allowing people to engage in tax avoidance without limits leads to abuse. Aggressive and abusive tax planning is one of the five main tax compliance risks in Canada. Other countries, through the judiciary, have created court-led anti-avoidance principles based on business purpose and economic substance tests.
The economic substance doctrine is a common law judicial doctrine that disallows tax benefits of a transaction if the transaction lacks economic substance or a business purpose. The goal of this doctrine is to prevent taxpayers from subverting the legislative purposes of the tax code. It is above the legal standards, which looks to see if the letter of law is followed, to see if the spirit of the tax law was followed. The taxpayer must prove that the underlying economic transaction was not concocted simply to avoid or reduce tax liability, but that there is an economic reality to the transaction. That is, the transaction or series of transactions also creates economic value or profits, other than the tax savings. In particular, economic substance test respects the fact that transactions with similar economic consequences are taxed similarly.
In Canada, however, no such test developed through the judiciary. It pretty much came to a head in the Subart ruling in 1984 when the courts affirmed the Duke principle and that a business purpose test was inconsistent with achieving economic policy through the ITA. This then created the prime opportunity for taxpayers to become much more aggressive in their tax avoidance activities and led to a large growth of tax shelters.
Parliament, not pleased with this situation, then embarked on the creation of a General Anti-avoidance Rule (GAAR) which was codified into the ITA in 1988. The idea of GAAR was to stop the cycle of complex, specific tax measures aimed at sophisticated business practices, and inevitably, professionally guidance and equally specialized reaction. While there are many sections of the act that refer to anti-avoidance (specific anti-avoidance), GAAR was supposed to serve as an overarching rule informing the entire Act unlike the other anti-avoidance rules that suffer from a lack of breadth. GAAR was intended to distinguish between legitimate tax planning and abusive tax avoidance, requiring the Duke principle to be united with GAAR.
Economic substance was envisioned by Parliament to be part of the GAAR, because in the explanatory notes accompanying the draft legislation it said the provisions of the income tax act are intended to apply to transactions with real economic substance, not to transactions intended to exploit, misuse, or frustrate the Act. Therefore transactions lacking economic substance should be presumed to frustrate the legislative purpose of the income tax act. However, an economic substance test was not directly incorporated into section 245 of the ITA.
The case law shows a very cautious application of GAAR and an uncomfortableness with economic substance, often playing in the background rather than featuring in the decision. And because future cases look back at past cases for their decisions, this feature of not applying or developing a clear test has become somewhat entrenched in the application of GAAR at the judicial level. In fact, in looking at the court cases it is clear that an application of economic substance is needed but more guidance to the courts is needed.
It has been suggested that this has arisen because the courts have preferred to look at legal substance or the legal form whereas economic substance requires textual, contextual, and purposive analysis. The textual contextual and purposive analysis is to determine what the words of the ITA mean so as to determine the object, spirit, or purpose of the provision. It is a search for rationale. Economic substance is a search for rationale and so is consistent with this approach.
The SCC has specifically said that absent a specific provision to the contrary, it is not the courts role to prevent taxpayers from relying on the sophisticated structure their transactions arranged in such a way that the particular provisions of the Act are met. The courts role is to interpret and apply that Act as it was adopted by Parliament, not necessarily the explanatory notes. What the courts have said is that the act of searching for policy and then to use such policy to override the wording of the provisions in the ITA would place the formulation of tax policy in the hands of the court.
The courts have, therefore, concluded that the concept of economic substance has no relevance without a specific statutory provision that makes it relevant.
Adding an economic substance test is consistent with most legal analysis of the situation in Canada regarding abusive and aggressive tax planning. Without the economic substance test or similar test many abusive transactions will not be found to be such. E.g Offshore beneficial trusts, which have flourished as a tax shelter.
Canada is an outlier not having an economic substance test. For example, the US economic substance test developed in the courts in response to a waive of tax shelters set up in the 70s and 80s, the same tax shelters Canada was responding to when it enacted the GAAR. The US economic substance test was codified in 2010 into the ITA following the global financial crises (a need for revenues and discouraging the use of tax haves). The enactment was given significant teeth by enacting high civil penalties.
The US is a good example as real economic substance to transactions is what was in the mind of parliament when GAAR was enacted. The US defines a transaction as having economic substance (sham transaction) if (1) the transaction changes in a meaningful way (apart from its federal income tax effects) the taxpayer’s economic position ( subjective intent, whether the taxpayer had a non-tax business goal for the transaction); and (2) the taxpayer has a substantial purpose (apart from those tax effects) for entering into the transaction (objective intent, whether the non-tax business goal had a reasonable or expectation possibility of profit). The US provision is accompanied by a general directive that gives guidance on how to determine if the doctrine applies.
We should not overlook the role of tax accountants and tax lawyers in creating abusive tax shelters that lack economic substance. Tax professionals contribute majorly to abusive tax avoidance, benefit greatly from its persistence, and have significant capacities to reduce its extent. Tax professionals ought to do much more to address tax avoidance than merely comply with existing legislation. These responsibilities are consistent with widely accepted standards of professional integrity. A way to nudge better professional standards is to adopt penalties for those who promote abusive tax shelters, as the UK, US, and Quebec has done.
Further, Canada does not currently impose penalties when the GAAR does apply. If a transaction or series of transactions is found to run afoul of GAAR, only the tax owing is assessed. This is contrary to other jurisdictions, like the US and Quebec, which levy penalties as well and may also help reduce aggressive and abusiveness tax avoidance.
Of course, we all know a key problem is learning about these abusive tax shelters in the first place. Some jurisdictions, including Quebec, impose mandatory disclosure of potentially abusive tax shelters. The advantage of disclosing tax shelters in advance is that it provides information to the tax authority for it to investigate. Why would a tax planner disclose a tax shelter? If disclosed if found to be against the general anti-avoidance provisions, the aforementioned penalties would not be applied due to the disclosure.
There is a lot of talk in Canada about how immoral these tax shelters are and more should be done to stop them. That is easier said then done, but Murray Rankin is right to push the Government to enact an economic substance test. I just hope it is one with teeth.