Revised proposals to amend the general anti-avoidance rule

On August 4^th, 2023, the Department of Finance Canada (“Finance”) released draft legislative proposals which included revised proposals to amend the general anti-avoidance rule (the “GAAR”) in section 245 of the Income Tax Act (Canada) (the “ITA”) (the “Revised GAAR Proposals”). The revised proposals follow several GAAR proposed amendments initially introduced in the 2023 Federal Budget (“Budget 2023”) tabled on March 28^th, 2023.

The proposals to amend the GAAR will apply to transactions that occur on or after January 1^st, 2024, except for the amendments to the preamble to the GAAR and related provisions which will come into force on Royal Assent.

Preamble

Budget 2023 proposed the addition of a three-part preamble to the GAAR. The explanatory notes to the Revised GAAR Proposals (the “Explanatory Notes”) outline that the aim of the preamble is to highlight the purpose and scope of the GAAR to ensure the GAAR is applied as intended, although it is not actually a part of the GAAR analytical framework.

The language used in the preamble proposed in the Revised GAAR Proposals is similar to the wording proposed in Budget 2023, except for the removal of the statement that the GAAR can be applied “regardless of whether a tax strategy is foreseen.” Initially, this statement was included in Budget 2023 in response to a comment made by the Supreme Court of Canada (“SCC”) in Canada v. Alta Energy Luxembourg S.A.R.L.(“Alta Energy”), where the majority asserted that “[t]he GAAR was enacted to catch unforeseen tax strategies.”[1] In Alta Energy, the SCC ruled that the GAAR did not apply, noting that Parliament was aware of the taxpayer’s tax strategy, but had not introduced any provisions to prohibit its use.

However, subsequent to Budget 2023, the SCC released Deans Knight Income Corp. v. Canada (“Deans Knight”), which confirmed that GAAR can apply whether or not the tax strategy was foreseen. The majority in Deans Knight stated that “the GAAR is not limited to unforeseen situations it is designed to capture situations that undermine the integrity of the tax system by frustrating the object, spirit and purpose of the provisions relied on by the taxpayer” [emphasis added].[2]  The Explanatory Notes confirm that the statement “regardless of whether a tax strategy is foreseen” is no longer needed since the SCC has clarified that GAAR is no longer limited to unforeseen situations.

Economic Substance

Budget 2023 proposed a new economic substance rule to the misuse or abuse test. This rule states that if an avoidance transaction significantly lacks economic substance, then it “tends to indicate” misuse or abuse, and therefore the transaction could constitute abusive tax avoidance. Budget 2023 emphasized that the new economic substance rule would not supplant the existing legal form approach in Canadian tax law.

Budget 2023 provided a non-exhaustive list of factors to consider when assessing the economic substance of a transaction (the “List of Factors”), the presence of one or more of which “tends to establish” a lack of economic substance. The List of Factors included:

1. no substantial change in the opportunity for gain or profit and risk of loss of the taxpayer, and non-arm’s length persons, including because of:
   i. a circular flow of funds;
   ii. offsetting financial positions; or
   iii. the timing between steps in the series;
   
2. it is reasonable to conclude that the expected value of the tax benefit exceeds the expected value of the non-tax economic return (which excludes foreign tax benefits); and
   
3. it is reasonable to conclude that the entire, or almost entire, purpose for undertaking or arranging the transaction or series was to obtain a tax benefit.

The Revised GAAR Proposals replace “tends to indicate”, with a rebuttable presumption that when an avoidance transaction significantly lacks economic substance, it is presumed to involve misuse or abuse. Similarly, the Revised GAAR Proposals replace “tends to establish” with “establish,” but still dependent on specific circumstances. This shift now places the responsibility on the taxpayer to challenge the presumption of misuse or abuse when dealing with transactions significantly lacking economic substance in the misuse or abuse test.

The Explanatory Notes clarify that the presumption can be rebutted by the taxpayer in “appropriate circumstances.” For example, the presumption can be rebutted by demonstrating that a particular provision of the ITA was enacted to encourage the outcome of a specific avoidance transaction, even if it lacks economic substance. The Explanatory Notes provide two examples of situations where this rebuttal could exist: (1) when transferring funds to a tax-free savings account; and (2) in certain loss utilization transactions within a related group.

The second and third points in the List of Factors remain unchanged in the Revised GAAR Proposals, but an addition is made to the first point. The Revised GAAR Proposals add the use of an “accommodation party” as a consideration that may establish that a transaction or series of transactions is significantly lacking in economic substance. The Explanatory Notes clarify that an accommodating party is a party that, whether directly or indirectly, can receive a facilitation fee for involvement in a transaction and aid the taxpayer in securing a tax benefit, all while bearing minimal or no significant economic exposure associated with the transaction.

The Explanatory Notes provide two examples of circumstances where the first factor may be relevant because there is no change in economic position:

• Shifting rights or assets from one subsidiary to another within a group in circumstances where the economic position of the group has not changed, and
• Transactions between shareholders and corporations that they control.

Notably, the Explanatory Notes also state that the first factor might be less relevant in the context of genuine commercial transactions between family members.

Another interesting point is that proposed subsection 245(4.2) of the ITA omits the word “includes” before the list of factors in the Revised GAAR Proposal. Consequently, there can be uncertainty as to whether these factors constitute an exhaustive list. Additionally, the proposed section’s wording does not explicitly specify if all enumerated factors must be met, or if meeting just one or two of them is sufficient to establish a significant absence of economic substance. However, the Explanatory Notes clarify that the list of factors is not exhaustive, and that meeting all enumerated factors is not a prerequisite for the application of subsection 245(4.2) of the ITA.

Penalty

Budget 2023 introduced a new penalty calculation for transactions subject to the GAAR, equal to 25% of the tax benefit derived from such transactions. This penalty does not apply if the transaction was disclosed according to the reportable transaction rules, including the suggested optional disclosure rules, or the notifiable transaction rules. Notably, Budget 2023 stated that if the tax benefit in question pertains to an unutilized tax attribute, it would not be included in the penalty calculation.

The Revised GAAR Proposals propose several adjustments to the proposed GAAR penalty in Budget 2023. Instead of being determined by reference to the amount of the tax benefit, it will now be based on the increased tax payable due to the GAAR’s application, excluding any penalties imposed under the gross negligence provisions to avoid duplication.

The rule states that the penalty is applicable to GAAR-subject transactions, or series of transactions, with the penalty’s amount for each tax year calculated using the following formula:

(A – B) x 25% – C

where

A = the tax payable by the person under the Tax Act for the year;

B = the tax that would have been payable under the Tax Act if the GAAR did not apply; and

C = the amount of any gross negligence penalty payable by the person under subsection 163(2) of the ITA in respect of the transaction or series and that did not reduce the penalty payable under this subsection in a preceding taxation year.

Given the change in penalty calculation method, the previously required deeming rule concerning unutilized tax attributes is no longer necessary. However, the Explanatory Notes confirm that if the tax benefit obtained pertains to the establishment of a tax attribute, no penalty will be levied until the year in which the tax attribute is used to reduce the tax liability.

The Revised GAAR Proposals include an exception to the penalty provision, allowing a taxpayer to avoid the penalty if they can demonstrate that at the time a transaction or series was entered into “it was reasonable for the person to have concluded that [the GAAR] would not apply to the transaction or series in reliance on the transaction or series being identical or almost identical to a transaction or series that was the subject of (1) administrative guidance or statements that were published by the Minister or another relevant government authority, or (2) one or more court decisions.” This legislative exception for “administrative guidance or statements” in the GAAR penalty due-diligence defence is significant because Canadian jurisprudence has held that such guidance or statements are not necessarily binding.

Furthermore, the Explanatory Notes state that the threshold of “identical or almost identical” is quite high, so utilizing the same tax strategy or engaging in a transaction that is only similar may not be sufficient for this exception to apply. The Explanatory Notes confirm that the exception applies at the time of entering into the transaction or series of transactions, therefore, it can be relied upon even if administrative guidance or legal precedent subsequently changes.

Extended Reassessment Period for GAAR assessments

In Budget 2023, a proposal was made to extend the typical reassessment timeframe by three years for assessments arising from the GAAR’s application, unless the transaction had been disclosed under the reportable transaction rules per section 237.3 of the ITA, which includes the optional disclosure rule. The Revised GAAR Proposals extend this extension to notifiable transactions under section 237.4 of the ITA.

The Revised GAAR Proposals allow for late filing of the optional disclosure under the reportable transaction rules up to one year after the taxpayer’s filing due date. If a taxpayer files an optional disclosure late, then the reassessment period is only extended by one year (as opposed to three years if the optional disclosure was not filed).

Revised Definition of Avoidance Transaction

Currently, an “avoidance transaction” is defined under subsection 245(3) of the ITA as a transaction that yields a tax benefit, whether directly or indirectly, unless the transaction may reasonably be considered to have been undertaken or arranged primarily for bona fide purposes other than to obtain the tax benefit.

Budget 2023 proposed to amend this definition to state that an avoidance transaction will exist only if it was reasonable to consider that obtaining a tax benefit was “one of the main purposes” to have been undertaken or arranged. However, the Revised GAAR Proposals further revise the wording of this definition to state that an avoidance transaction will not arise if it is reasonable to consider that obtaining a tax benefit was “not one of the main purposes” for undertaking the transaction. Presumably, there is no intended substantive difference between the definition proposed in Budget 2023 and the definition proposed in the Revised GAAR Proposals. The Explanatory Notes state that the sole intended effect of the amendments is to change the “primarily” threshold in the avoidance transaction test to a “one of the main purposes” threshold.

[1] At para 81.

[2] At paras 45 and 153.