In the recent case of Canada v. Deans Knight Income Corporation, 2021 FCA 160, the Federal Court of Appeal addressed the object, spirit, and purpose of subsection 111(5) of the Income Tax Act in the context of determining whether there had been abuse for the purposes of the GAAR.
The wording of subsection 111(5) itself refers to a de jure control test. It is one of the provisions known as the stop-loss rules which restrict a corporation’s ability to deduct losses when there has been an acquisition of control. There have been a number of amendments to the stop loss rules over the years; however, none of them sanction the replacement of a de jure control test with a de facto control test. Prior jurisprudence had indicated that using de jure control was a deliberate choice by Parliament to provide certainty. Whatever certainty the wording of the subsection itself provided now appears to be lost due to the risk of GAAR assessments.
Prior jurisprudence such as Duha Printers (Western) Ltd. v. Canada, [1998] 1 SCR 795 and the Tax Court decision in Deans Knight indicated that Parliament had specifically chosen to use de jure control for the purpose of subsection 111(5) and that a change should be left to Parliament. Despite this, the FCA adopted an expanded concept of control as part of the object, spirit, and purpose of subsection 111(5). The FCA discussed Duha Printers and took the view that the GAAR, which was not in force at the time relevant to that case, was a form of response allowing the courts to look beyond the concept of de jure control in the provision. The FCA’s definition of the object, spirit, and purpose uses the term “actual control” “whether by way of de jure control or otherwise”.
The FCA’s test does not refer to de facto control and indeed the decision suggests that “actual control” “includes forms of de jure control and de facto control.” It is possible that “actual control” could be interpreted as a new form of control. In that case there is now a high degree of uncertainty about the type of control that could trigger a GAAR assessment with relation to the misuse or abuse of subsection 111(5) and similar provisions. Further jurisprudence will likely be necessary to confirm what “actual control” means, whether it should be taken as a new form of control, and if so, how it differs from de facto control as currently understood.
As a practical matter, it seems probable that the factors which would be relevant to the analysis of “actual control” for this purpose will be similar to factors which would be relevant to a de facto control analysis as previously understood. The examples which the FCA referred to in concluding that the transaction was abusive are points that would also be relevant for de facto control and largely focused on the provisions of the investment agreement between the parties.
The investment agreement was between Deans Knight, its shareholder, and the corporation providing the framework for the monetization (Matco Capital Ltd.). The investment agreement provided for payments based on the value of the tax attributes, i.e. losses. This included an initial payment of $3,000,000 and a potential further payment of $800,000 representing 21% of the total. The further payment could be withheld due to lack of compliance with obligations under the agreement or a rejection of a monetization opportunity identified by Matco. The court found the obligations backed by a contingency on 21% of the total funds sufficient to give Matco “actual control.” This is specific to the facts and does not provide overall guidance on the combination of obligations and financial consequences which will trigger “actual control.”
The FCA decision is certainly relevant to situations involving stop loss rules. It may also have broader implications for the application of the GAAR for other provisions which involve concepts of control. Subsection 111(5) has a history around the specific use of de jure control. If the object spirit and purpose of a provision with that history contains a broader idea of control, it is possible that other provisions which directly refer to de jure control will also have a broader concept as part of their object spirit and purpose. This should be taken into account when assessing GAAR risk.
Possible implications for Bill C-208 provisions
One relevant example of another situation where the CRA may seek to apply similar reasoning relates to the recent changes to the Income Tax Act made by Bill C-208. Those changes were the subject of a prior article. After initially indicating that it would not allow the changes to take effect, the Department of Finance (“Finance”) relented and acknowledged that Bill C-208 is in force. However, Finance indicated that further amendments will be forthcoming. In the meantime, the approach the FCA took in Deans Knight may provide the CRA with an opportunity to challenge certain types of transactions relying on the provisions of Bill C-208 which Finance may find abusive.
Bill C-208 was intended to facilitate intergenerational transfers of a business. Among other things, it amended section 84.1 (the “Amendment”). When section 84.1 is triggered, it causes a capital gain to be treated as a deemed dividend. Bill C-208 provided a carve out (the “Carve Out”) that deems a transfer by an individual (the “Transferor”) to a corporation controlled by a child or grandchild of the Transferor who is at least 18 years of age to be at arm’s length when certain conditions are met. When the Carve Out is applicable, section 84.1 would not be triggered because it only applies to a transfer by an individual to a corporation that does not deal at arm’s length with the individual.
The Amendment does not refer to control directly or indirectly in any manner whatever and a de facto control test. Based on the text of the Amendment itself, a situation involving a corporation where the child has the majority of the votes and therefore de jure control could qualify for the Carve Out. This would be the case even where the child’s votes do not represent a significant amount of the value of the corporation and the child is not otherwise involved in the business.
While such a transfer would fall within the wording of the Amendment currently enacted, it does not seem to fit within the goal of promoting the transfer of businesses within families. It could also lead to forms of surplus stripping which does not appear to be what legislators intended when they voted to enact the provision.
Prior to Deans Knight, it was not clear whether the CRA could have successfully challenged an arrangement which used the Amendment to effect a surplus strip where a child obtained de jure control of the corporation and the parent retained de facto control. Deans Knight assists the CRA with an argument that such a transaction would be outside of the object, spirit, and purpose of the provision and that the GAAR applies to preclude the application of the Carve Out to section 84.1. In particular, they could argue that the Carve Out does not apply because the object, spirit, and purpose of the provision requires that the child has “actual control” and not merely de jure control.
Given the decision in Deans Knight and the reaction of the Department of Finance to Bill C-208, it is likely any transactions relying on the Amendment as it currently exists will be subject to close scrutiny. Anyone intending to rely on Bill C-208 should exercise extreme caution.
This article was originally published in Wolter Kluwer Tax Topics. Republished with permission.
Brian Nichols and Kelsey Horning of Goldman Sloan Nash & Haber LLP, Toronto. Brian Nichols practises law through Brian Nichols Professional Corporation.