By Colleen McMullin of Gowling Lafleur Henderson LLP
Introduction
The Federal Court of Appeal has recently provided much needed clarification on the parameters of the controversial General Anti-Avoidance Rule (the “GAAR”), which has left many corporate tax advisors breathing a temporary sigh of relief. The rule, contained in section 245 of the Income Tax Act, may be asserted against taxpayers who are in technical compliance of the law, but, in the opinion of the Canadian Revenue Agency (the “CRA”), have participated in a transaction that resulted in a “misuse” or “abuse” of the provisions of the Act.1
Since its enactment in 1988, a great deal of uncertainty has entered into the realm of tax planning. More than two decades later, this uncertainty still abounds today. Taxpayers and tax planners alike are unable to predict with any degree of certainty whether or not they have structured their affairs in a way which will avoid CRA scrutiny, despite complying with the letter of the law. Contributing to this atmosphere of doubt is the Agency’s tendency to use the GAAR as a tool to make retroactive determinations of the appropriateness of a transaction – a process which critics claim has more to do with the quantum of the assessment, and less to do with any well-founded principles of tax law.
In order for the GAAR to apply, the taxpayer must have enjoyed a tax benefit (i.e. a reduction, avoidance or deferral of income tax), have entered into an avoidance transaction (i.e. a transaction undertaken primarily for a tax benefit), and engaged in abusive tax avoidance (i.e. the tax benefit enjoyed as a result of the avoidance transaction frustrated or defeated a specific provision of the Income Tax Act).
In Lehigh Cement v. The Queen, the issue under appeal was whether or not Lehigh Cement Limited (“Lehigh”), a corporation resident in Canada, should be responsible for assessments made for unpaid non-resident withholding tax on interest paid in the years 1998 to 2002 to Bank Brussels Lambert (the “Belgium Bank”). Specifically, the court had to determine if the CRA’s assessments were justified by the GAAR.
Facts
Lehigh was a member of a related group of corporations (the “HZ group”), which included a Belgian corporation named CBR International Services S.A. (“International Services”). In 1986, Lehigh borrowed $140 million from a consortium of Canadian banks. It later sold the loan (the “Lehigh debt”) to one of the corporations within the HZ group. Ownership of the debt changed several times but by August of 1997, International Services held the Lehigh debt. While the Lehigh debt was held by a foreign corporation, the interest was subject to non-resident withholding tax pursuant to subsection 212(1) of the Income Tax Act. Lehigh withheld the tax and paid it as required.
The Lehigh debt had a floating interest rate based on the Canadian prime rate, which was expected to increase dramatically. Thus in January of 1997, Lehigh began exploring ways to restructure the debt so as to avoid the non-resident withholding tax. Predictions indicated that the present value of the tax saving that could be achieved would be upwards of $13.1 million, depending upon the interest rate chosen. The HZ group determined that the market interest rate for the Lehigh debt was 7%.
In August of 1997, the terms of the Lehigh debt were amended to provide the following:
(a) The interest rate was changed from the Canadian prime rate to a fixed rate of 7% for the first five years.
(b) Except in the event of a default, Lehigh was not obliged to repay more than 25% of the principal amount within 5 years of the date upon which the new terms were agreed to.
(c) The holder of the Lehigh debt (then International Services) was given the right to sell to a third party all or any portion of the right to be paid interest on the loan.
(d) A withholding tax gross-up clause was added. That is, Lehigh agreed that if any withholding tax was payable on the interest, Lehigh would effectively bear the increased cost.2
Later the same month, International Services sold to Belgium Bank the right to be paid all interest payable on the Lehigh debt before September 16, 2002, totalling approximately $49.5 million.
The Section 212(1)(b)(vii) Exemption
Section 212(1), the section proscribing the withholding of tax on Canadian source income of a non-resident, allows for numerous exceptions, as outlined in subsection (b). The seventh listed exemption, as it was during the time relevant to the appeal, provided an exemption from non-resident withholding tax for interest payable by a corporation resident in Canada to a non-resident person. In order to qualify for the exemption, two conditions had to be met. First, the two parties must have satisfied the arm’s length test – meaning the resident of Canada and the person to whom the interest was payable must not have been engaged in any special relationship that would have prevented each from pursuing its own best interests. Second, the resident of Canada must not have been obliged to pay more than 25% of the principal amount of the debt within five years of the date of issue of that obligation, except in the event of default.
In reliance on this provision, after August of 1997, Lehigh ceased withholding any tax on the interest owed to the Belgium Bank. Despite meeting both the five year and arm’s length tests, the CRA contended that the non-resident withholding tax was payable on the interest on the basis of the application of the GAAR.
Position of the Crown
The Crown insisted that “the purpose of subparagraph (vii) [was] to help Canadian corporations needing to borrow money by increasing their access to international capital markets.”3 As the cost of the withholding tax is frequently borne by the Canadian borrower, the Crown asserted that the exemption was aimed at making borrowing from foreign lenders more competitive with domestic borrowing. Because Lehigh did not borrow any capital from a non-resident lender, the Crown insisted that the disputed transactions amounted to a frustration of the object, spirit and purpose of subparagraph (vii). Further, the Crown claimed that the exemption relied upon was “not intended to apply to a non-resident person who [was] legally entitled to be paid interest on a debt as a result of a transaction by which the right to be paid the interest [was] split from the right to be paid the principal amount.”4
Position of Lehigh
Lehigh argued that the wording of the Act indicated that non-resident withholding tax did not need to be paid on interest if the arm’s length test and the five year test were met. The arm’s length test was “intended to ensure that the contractual conditions governing the debt, particularly the interest rate, fairly reflect[ed] the applicable market,” while the five year test was intended “to ensure that the debt [was] a medium to long term debt.”5 The debt in issue was certainly long term, and the Crown conceded that the interest rate was the market rate. Lehigh submitted that since the conditions of subparagraph 212(1)(b)(vii) were met when considering both the legal and economic substance of the transaction, there could be no foundation upon which the Crown could base its claim that there was a misuse of the statute.
Discussion
The Federal Court of Appeal unanimously rejected the Crown’s contention that the transaction in issue amounted to a misuse of the Act. Fatal to its argument was the absence of any provision of the Act that supported its determination of the fiscal policy underlying the exemption contained in subparagraph (vii). The sole basis for its argument rested on a single sentence in a budget paper released by the Department of Finance in 1975. The paper, which was published when the enactment of the original version of subparagraph 212(1)(b) was proposed, contained the following:
The proposed relief from withholding tax is intended to increase the flexibility of Canadian business to plan long-term debt financing and facilitate access to funds in international capital markets.6
The Court flatly dismissed the sufficiency of this sentence as justification for application of the GAAR. It further delineated that the GAAR may not be used as a form of “catch-all” provision that can be asserted whenever a taxpayer receives a tax benefit that was not contemplated by Parliament:
…[T]he fact that an exemption may be claimed in an unforeseen or novel manner, as may have occurred in this case, does not necessarily mean that the claim is a misuse of the exemption. It follows that the Crown cannot discharge the burden of establishing that a transaction results in the misuse of an exemption merely by asserting that the transaction was not foreseen or that it exploits a previously unnoticed legislative gap.7
If the Crown wishes to argue that there has been a misuse or abuse of the Act, it must “establish by evidence and reasoned argument” that the result of the disputed transaction is “inconsistent with the purpose of the exemption, determined on the basis of a textual, contextual and purposive interpretation of the exemption.”8
Inconsistency of the Crown
Besides the “shaky foundation” upon which the Crown based its fiscal policy argument, it is also interesting to note a hole in its reasoning that was pointed out by the Court.9 The Crown conceded that had International Services sold the right to be paid both the principal amount of the debt and the interest, there would have been “no basis for invoking the general anti-avoidance rule.”10 Yet, such a hypothetical transaction would not provide Lehigh with “access to funds in international capital markets.” It is difficult to reconcile the Crown’s assertion that Lehigh’s actions misused the Act, with their admission that such a hypothetical sale would not result in an abuse of the Act, despite the fact that in both scenarios “no foreign capital would have flowed to any Canadian corporation.”11
Conclusion
It would be a heavy burden to refute the accusation that the CRA was once again motivated into attacking the appropriateness of a transaction on the basis of the quantum involved. Lehigh is proof that even when one’s affairs are structured in a manner that is consistent with the wording of the Income Tax Act, and complies with its provisions from both a legal and economic standpoint, the GAAR could still be asserted. One would hope that the CRA returns to pursuing taxpayers on the basis of well-founded principal-based claims, rather than ad hoc attempts to attack legitimate tax planning.
1. Income Tax Act, R.S.C. 1985 (5th Supp.), c.1, s. 245.
2. Supra note 1 at para. 14.
3. Ibid. at para. 19.
4. Ibid. at para. 25.
5. Ibid. para. 24.
6. Canada, Department of Finance, Budget: Highlights and Supplementary Information (Ottawa: June 23, 1975) at 21.
7. Supra note 1 at para. 37.
8. Ibid. at para 37.
9. Ibid. at para. 35.
10. Ibid. at para. 40.
11. Ibid.
