Decision deals with Income Tax Act provision restricting when business losses can offset tax burden
In dismissing its appeal, the Supreme Court of Canada found that a company used a complex series of transactions to circumvent a restriction in the Income Tax Act intended to prevent companies from purchasing others for the sole purpose of using the target’s business losses to reduce their tax burden.
Deans Knight Income Corp. v. Canada, 2023 SCC 16 dealt with the general anti-avoidance rule and s. 111(1)(a) of the Income Tax Act, which allows a taxpayer to use non-capital losses to offset income to lower their tax rate in another tax year. A non-capital loss represents the deficit when a business’s annual expenses exceed its yearly income. To prevent companies from acquiring each other just to capitalize on the target’s non-capital losses, s. 111(1)(a) restricts an acquired company from carrying over the non-capital losses unless the acquirer carries on the same business or a similar business as the company that incurred the losses.
“The Canada Revenue Agency welcomes the Supreme Court of Canada decision,” says CRA spokesperson Sylvie Branch. “The CRA remains committed to combatting tax avoidance which erodes Canada’s tax base and undermines the government’s ability to provide important benefits and services to Canadians.”
Counsel for Deans Knight, Heather DiGregorio, says the SCC has taken an approach that obscures the boundaries of the anti-avoidance rule and departs from the “principled approach” established in Canada Trustco Mortgage Co. v. Canada, 2005 SCC 54.
“As a result of this decision, taxpayers now face a mountain of uncertainty in planning their affairs,” says DiGregorio, who acted for the appellant with co-counsel Barry Crump.
The appellant in Deans Knight Income Corp. v. Canada had accumulated $90 million in non-capital losses, scientific R&D tax expenditures, and investment tax credits. The company, which was operating under the name Forbes Medi-Tech at the time, was struggling and lacked any income to offset with the losses.
Forbes struck an agreement with a venture capital firm, Matco, moving its assets and liabilities into a new parent company called Newco. Matco then bought debentures that would convert into some voting shares and all of Newco’s non-voting shares in Forbes. Newco promised to sell Matco a certain number of shares.
Then, Matco found a new business venture, a mutual fund management company called Deans Knight Capital Management. Deans Knight used Forbes to raise money in an IPO, and Forbes changed its name to Deans Knight. Their subsequent business venture succeeded, and Deans Knight used Forbes’ non-capital losses to reduce its tax liability in the 2009 and 2012 tax years.
Canada Revenue Agency reassessed its tax bills and denied Deans Knight the deductions. The company appealed to the Tax Court. The CRA argued that the deductions constituted abusive tax avoidance under the general anti-avoidance rule in s. 245 of the Income Tax Act, but the Tax Court held that the transactions and resulting tax benefit were not abusive. The Federal Court of Appeal disagreed, set aside the Tax Court’s judgment, and dismissed Deans Knight’s assessment appeal.
In a seven-to-one ruling, the SCC dismissed the company’s appeal, finding that the transactions were abusive and restoring the CRA’s initial reassessments. Justice Suzanne Côté dissented.
According to Justice Malcolm Rowe, who wrote the reasons for the majority, the “object, spirit, and purpose” of s. 111(5) prevents an unrelated party from acquiring a business simply to deduct its losses to benefit the new shareholders. In going from Forbes to Deans Knight, the company made a “fundamental transformation” in a “complex series of transactions,” which achieved an outcome Parliament sought to prevent.
The general anti-avoidance rule under s. 245 involves a three-step test: Was there a tax benefit? Was the transaction producing the benefit an “avoidance transaction?” And was that avoidance transaction abusive?
The only step at issue in the appeal was the third. To determine whether the transactions were abusive, the court examined whether they produced an outcome the provisions sought to prevent, defeated the provisions’ “underlying rationale,” or circumvented the provisions in a manner that frustrated their object, spirit, and purpose.
According to Rowe, section 111(5)’s text, context, and purpose reveal the underlying rationale. The text of the provision references “control,” which courts have interpreted to mean “de jure control.” To achieve de jure control, the controlling party must hold enough shares to “elect the majority of the board of directors.” Section 11(5) also creates an exception. Deductible losses can be carried over in an acquisition if the resulting corporation “engages in the same or a similar business,” which reflects an intention to deny carryovers “where there is lack of continuity within the corporation,” he said.
But Rowe said that the s. 111(5)’s rationale is “not fully captured” by the de jure test, as the provisions suggest that “de jure control is not a perfect reflection or complete explanation of the mischief that Parliament sought to address.”
Côté would have found that the avoidance transactions did not frustrate the rationale of s. 111(5) and were therefore not abusive. While the provision requires the new entity to achieve “de jure control” of the business to trigger the carryover restriction, the majority adopted “an ad hoc approach,” which “expands the concept of control based on a wide range of operational factors” and invites “the exercise of unbounded judicial discretion,” she said.
The majority’s approach to determining the object, spirit, and purpose of s. 111(5) missed a “central principle” from Canada Trustco Mortgage Co. v. Canada, 2005 SCC 54, said Côté. The general anti-avoidance rule “does not and cannot override Parliament’s specific intent regarding particular provisions of the Act… The [general anti-avoidance rule] was intended to catch unforeseen tax strategies, but if Parliament drafts a specific anti-avoidance provision in a way that keeps a highly foreseeable gap open, the gap is more likely to be intentional, and relying on it should not be considered abusive,” she said.
Côté disagreed with the majority on what constitutes de jure control. A textual, contextual, and purposive analysis of s. 111(5) demonstrates that Parliament only intended for courts to consider share ownership in determining who controls a corporation. The majority “treats the investment agreement as a constating document for the purposes of control,” which ignores that these documents are enforced “in radically different ways” and that constating documents and ordinary contracts can never be “functionally equivalent.” The general anti-avoidance rule cannot override Parliament’s clear intent, and “the majority’s approach departs from Parliament’s clear articulation of a de jure control test for restricting losses under s. 111(5),” she said.
An intervenor, the Canadian Chamber of Commerce, took no position on the case’s outcome or the facts related to Deans Knight but got involved because of the potentially far-reaching and important implications to how courts will determine “object, spirit, and purpose,” says counsel Steve Suarez. A partner at Borden Ladner Gervais, Suarez notes he spoke to Canadian Lawyer personally and not on behalf of the Chamber.
He says the SCC did not use this case to provide “more generally applicable guidance” on determining object, spirit, and purpose or the legislative rationale when applying the general avoidance rule. “As such, this decision is of limited precedential value going forward.”
Suarez hopes that in a future case, the court will further clarify the relevant factors in determining the legislative rationale of provisions in the Income Tax Act, which would help taxpayers stay on the right side of the law, make abusive tax avoidance more difficult to sustain, and “reduce the ever-growing time and expense spent on tax controversy.”
“In the meantime, taxpayers and their advisors should expect the CRA to continue to apply [the general anti-avoidance rule] aggressively in a very results-oriented, ‘smell test’ manner in the hope that a court can be convinced to go along in a process where the government has all of the advantages,” says Suarez.
He adds that it was “somewhat reassuring” that the majority based its decision on Matco achieving “the functional equivalent” of the de jure test, which means it accepted the de jure control standard found in s. 111(5) as “the benchmark that constituted where Parliament had drawn the line for when a corporation’s losses should be restricted.”
“In so doing, the court rejected the Crown’s invitation to apply [the general anti-avoidance rule] on the basis of some lesser degree of control and significantly limited the precedential impact of the case.”