The most important event in Canadian tax litigation was the decision of the Supreme Court of Canada on June 24, 2004, to hear two tax cases involving the general anti-avoidance rule ("GAAR"). The cases, Kaulius v. The Queen1 and The Queen v. Canada Trustco Mortgage Company,2 will be the first cases heard by the Supreme Court of Canada where GAAR is the central issue. Another important case decided in the last year deals with the deduction of legal and financial fees incurred in fighting a takeover bid and seeking a white knight. Also, the Supreme Court of Canada in three separate cases reinforced the fundamental importance of solicitor-client privilege. Lastly, on a procedural matter, the Federal Court of Appeal sent a clear message to large corporations about the necessity of filing a comprehensive notice of objection.
GAAR CASES AND THE SUPREME COURT OF CANADA
The courts have established a three-stage procedure to determine whether the GAAR applies:
- Determine whether the impugned transaction resulted in a tax benefit.
- Determine whether the transaction may reasonably be considered to have been undertaken primarily for purposes other than to obtain the tax benefit (if not, the transaction is an avoidance transaction").
- Determine whether the transaction results in a misuse of a provision or provisions of the Income Tax Act ("the Act") or an abuse of the Act as a whole.
The granting of leave by the Supreme Court of Canada in Kaulius came as a surprise, since the Court had denied leave in OSFC Holdings Ltd. v. The Queen3 and the facts in the Kaulius appeal were for practical purposes the same as in the OSFC Holdings case. Standard Trust Company ("Standard") lent money on the security of mortgages on real property. Standard became insolvent. In order to maximize the recovery from the disposition of Standard's assets, the liquidator caused a series of transactions to occur that would have the effect of transferring the unrealized losses on the mortgages to third parties who, at the time of the transaction, were not yet known to Standard. More specifically, Standard and a wholly-owned subsidiary formed a partnership. Standard transferred the mortgages to the partnership and, by virtue of a specific statutory provision, the unrealized losses moved over to the partnership. Third parties after the preparatory transactions acquired the majority of the partnership interests. Losses were subsequently realized by the partnership, which flowed through to the new partners and were deducted by them.
In OSFC Holdings the court determined that the abuse analysis involves a two-stage process. The first stage requires the Minister to identify the relevant policy of the Act read as a whole. The second requires an assessment of the facts to determine whether the avoidance transactions constituted an abuse, having regard to the identified policy. In OSFC Holdings the court determined that the general policy of the Act is against the transfer of losses between arm's-length taxpayers. The court concluded that the transfer of Standard's losses to OSFC Holdings, an arm's length party, violated the general policy of the Act and was, therefore, an abuse of the Act read as a whole.
The appellants argued in Kaulius that the Federal Court of Appeal should overrule its prior decision in OSFC Holdings. The court noted that while it may overrule its own prior decisions, in the interests of certainty and consistency, the court should follow its prior decisions except in exceptional circumstances. Accordingly, the Federal Court of Appeal dismissed the taxpayer's appeal in Kaulius on the basis that the thrust of the taxpayer's argument was the same as in OSFC Holdings.
The taxpayers in Kaulius also raised two constitutional arguments. Section 53 of the Constitution Act provides that bills imposing tax shall originate in the House of Commons. The appellants argued that GAAR is so vague that it gives plenary taxing powers to the Minister.
The second argument was that GAAR violated section 7 of the Charter of Rights and Freedoms. Section 7 provides that everyone has the right to life, liberty and the security of person and the right not to be deprived thereof except in accordance with the principles of fundamental justice. The taxpayers submitted that the term "abuse" was incapable of being infused with "core" meaning and was therefore unconstitutionally vague.
The Federal Court of Appeal in Kaulius rejected both constitutional arguments on the basis that the relevant provision dealing with abuse was not unconstitutionally vague. The question according to the court is whether a law provides the basis for legal debate and coherent judicial interpretation. If judicial interpretation is possible, an impugned law is not vague.
In Canada Trustco the taxpayer was successful in arguing that the subject transactions did not constitute a misuse or abuse. The taxpayer, Canada Trustco, borrowed money from the Royal Bank and used these funds, together with some of its own funds, to purchase trailers from Transamerica Leasing Inc. ("TLI"). The taxpayer then leased the trailers to a U.K. company ("MAIL"), which subleased the trailers back to TLI. The latter prepaid the sublease to MAIL, which placed most of the funds it received on deposit with Royal Bank.
Canada Trustco reported leasing income (primarily from other leases) and deducted capital cost allowance ("CCA") in respect of the trailers against this leasing income.
The Canada Revenue Agency ("CRA") denied the taxpayer's CCA deduction in respect of the leased equipment on the basis that it did not incur any "cost" to acquire the equipment, since the taxpayer bore no economic risk in respect of the purchase price as a result of the lease prepayment. The tax court found that the GAAR did not apply to preclude the taxpayer from claiming CCA on the leased equipment since there was no clear and unambiguous policy that CCA could only be claimed on the economic, as opposed to the legal, cost incurred to acquire an asset.
The tax court concluded that it is the legal cost that is determinative, not the real economic cost. The tax court observed that the Supreme Court of Canada had stated that, absent a specific provision to the contrary, legal relationships must be respected. Such specific provisions that do require an investigation of the economics of the situation include the limited partnership "at risk" rules and the "limited recourse" debt rules. There were no such rules that applied to sale-leaseback transactions. The Crown's appeal was dismissed orally from the bench.
To date, the taxpayer has been overwhelmingly successful in resisting a GAAR attack, such that one commentator has written an article entitled "The Long, Slow, Steady Demise of the General Anti-Avoidance Rule."4 The tax community anxiously awaits the Supreme Court's decisions in Kaulius and Canada Trustco to see how much life remains in GAAR.
On March 8, 2005 the Kaulius and Canada Trustco Mortgage Company appeals were heard before the full panel of nine justices of the Supreme Court of Canada.
DEDUCTIBILITY OF EXPENSES INCURRED IN A HOSTILE TAKEOVER
On December 3, 2003, the Tax Court of Canada rendered its decision in BJ Services v. The Queen5 on the issue of deductibility of legal and financial fees incurred in fighting a takeover bid and seeking a white knight. The court held that takeover fees are deductible as costs incurred for the purpose of earning or producing income from the business.
The issue that the court addressed was whether expenses incurred in respect of shareholder relations and maximizing shareholder value could be considered as laid out for the purpose of earning income in the same way that expenses more directly connected with the conduct of day-to-day business are deductible. The former, referred to as ancillary expenses, were found deductible on the basis that shareholder confidence and ability to raise capital are essential to the operation of a business. The court went on to hold that expenses should be deductible when they satisfy a need of the company, even if ancillary, as long as they are not personal.
The court held that the expenses, viewed in the context of the commercial operations of the taxpayer, were necessary in dealing with the practicalities of a takeover bid. Adequate shareholder communication was stated to be a critical need at the time of a takeover bid in order for a board of directors to maintain its credibility and shareholder confidence. The taxpayer was obligated to react to the takeover bid with due diligence and in its best interest. Securities laws recognize the corporate objective of the protection of bona fide interests of shareholders in the face of a takeover bid. Hence, the expenses, although related to maximizing shareholder value, were so integral to the taxpayer's conduct of its business that they could not be divorced from the corporate activities of gaining or producing income. The court noted that shareholders provided the taxpayer with funding, and if this was lost or withdrawn, customers would be lost, staff laid off and eventually even the taxpayer's operations could shut down. Maximizing taxpayer value was tied to the bare bones of gaining or producing income on a daily basis.
The court also held that the expenditures incurred in this matter were not capital in nature as they were incurred for the purpose of gaining or producing income and not to obtain an enduring benefit. In light of this decision, corporations can now deduct fees incurred in response to takeover bids or other forms of reorganization as part of expenses incurred in gaining or producing income.
SOLICITOR-CLIENT PRIVILEGE
Three recent decisions by the Supreme Court of Canada have upheld the sanctity of solicitor-client privilege: Maranda v. Richer, Foster Wheeler Power Co. v. SIGED Inc., and Pritchard v. Ontario (Human Rights Commission).6
GENERAL PRINCIPLES ARTICULATED IN THE TRILOGY OF CASES
In these decisions, the Supreme Court has clearly stated that a lawyer's obligation of confidentiality is necessary to preserve the fundamental relationship of trust between lawyers and clients and that protecting the integrity of this relationship is indispensable to Canada 's legal system.
The Supreme Court has confirmed that solicitor-client privilege will apply when there is (i) communication between a solicitor and client, (ii) for the purpose of seeking or giving legal advice and (iii) which is intended to be confidential. In Maranda, the Court stated that it regards solicitor-client privilege as more than merely an "evidentiary or procedural rule" but a "general principle of substantive law." The Court pronounced that solicitor-client privilege must be nearly absolute and that exceptions to it will be rare.
However, the Supreme Court has been clear in pointing out that not everything that occurs in the solicitor-client relationship falls within the scope of privileged communication. By example, the Court referred to cases where it was found that counsel was not acting in a solicitor-client relationship but simply acting as a conduit for the transfer of funds. The Court has acknowledged that the legal profession is evolving and "lawyers are increasingly being called upon to provide services in fields well beyond their traditional sphere of practice." The cautionary note here is that advice given by lawyers, not related to their legal training or expertise, may not be protected by solicitor-client privilege.
MARANDA V. RICHER
Maranda involved the search and seizure of documents from a lawyer's office in the course of a criminal investigation of one of the lawyer's clients who was suspected of money laundering and drug trafficking. There was no suggestion that the lawyer was connected in any way with the alleged criminal activities of his client.
A central issue in the case was whether the information in a lawyer's billings was covered by the scope of solicitor-client privilege. What was being sought was information about the amount of fees and disbursements the client had paid to the lawyer.
The Supreme Court considered the situation in which the information sought related only to seemingly neutral information, such as the gross amount of lawyer's fees and disbursements paid and no other details.
In an 8-1 decision, the Supreme Court held that there is a prima facie presumption that information, such as lawyer's bills, fall within the privileged category because of the inherent difficulties in determining the extent to which the information contained in lawyer's bills of account is neutral information. The Court held that payment of a lawyer's bill arises out of the solicitor-client relationship and that the amount of the fees must be regarded, as a general rule, as information that is protected by solicitor-client privilege. The obligation, they said, is on the Crown to make the allegation adequately in its application that the disclosure of the information would not violate the confidentiality of the solicitor-client relationship.
In a search and seizure situation, the Court has unequivocally stated that the Crown is under a duty to minimize any impairment of solicitor-client privilege that may arise from the procedure. This duty rests on the informant who applies for a search warrant, the authorizing judge and those responsible for executing it. The Court has stated that it would tolerate a search and seizure in which a relatively minimal amount of information was obtained from the lawyer that could have been gathered by other means. In Maranda, however, the search and seizure violated the duty to minimize, since half of the information seized could have been otherwise obtained. In general, the Court has indicated that there is an obligation on parties seeking information to first make every effort to obtain that information from available sources other than lawyers.
FOSTER WHEELER POWER CO. V. SIGED INC.
In Foster Wheeler, a law firm was involved on a long-term mandate with their municipal client lasting several years relating to the construction of a recycling and incinerator facility. The lawyers were involved from the initial review and approval stages through to the ensuing litigation initiated by Foster Wheeler following the cancellation of the project and the subsequent cancellation of their equipment contracts.
The lawyers for Foster Wheeler attempted to obtain details of certain communications between the lawyers and their municipal clients that they hoped would support their allegation that the municipalities had acted in "bad faith."
The Supreme Court was critical of questioning in the nature of a "fishing expedition" in which lawyers could be used as "a source of information for building cases against their own clients." The Court stated that this sort of questioning should be restrained as much as possible to minimize the encroachment on a lawyer's duty of professional secrecy.
The Supreme Court again upheld the presumption of solicitor-client privilege where a lawyer has been retained in his or her professional capacity. Citing Maranda, the Supreme Court held that where "a general mandate had been given to a lawyer for the purpose of obtaining a range of services generally expected of a lawyer…there is a presumption, albeit a rebuttable one, that all communications between a client and lawyer and the information they shared would be considered prima facie confidential in nature."
PRITCHARD V. ONTARIO (HUMAN RIGHTS COMMISSION)
This case involved the appeals of Ms. Pritchard from a decision by the Ontario Human Rights Commission. At issue was whether a legal opinion, provided by in-house counsel to an administrative board, was protected by solicitor-client privilege, namely, the privilege that exists between a client and his or her lawyer.
The Supreme Court cited R. v. Campbell,7 where Binnie J. held that when government lawyers, or corporate in-house counsel, provide legal advice to a "client department," solicitor-client privilege is engaged. The Supreme Court, however, cautioned that where government lawyers give policy advice outside the realm of their legal responsibilities, such advice is not protected by solicitor-client privilege.
NOTICES OF OBJECTION AND AMENDMENTS TO NOTICES OF APPEAL
A recent Federal Court of Appeal decision, Potash Corporation of Saskatchewan v. The Queen,8 has sent a clear message to large corporations about the necessity to carefully review with their lawyers any notice of objection filed. In Potash, the court held that the taxpayer's appeal of its reassessment was strictly limited to the items identified in its notice of objection.
The taxpayer was a "large corporation." A large corporation, in its notice of objection, must "reasonably describe each issue to be decided." The central issue in this case was the determination of the degree of specificity required in a large corporation's notice of objection to "reasonably describe" an issue.
In its notice of objection, the taxpayer had identified that the computation of "resource allowance" and "resource profits" was the issue in dispute. The taxpayer listed each of the specific items that the CCRA had disallowed and had excluded from the taxpayer's computation of resource profits, arguing that each item qualified as "resource profits." The relief sought in the notice of objection was a reduction of net income based on the inclusion of the listed items in the computation of "resource allowance" and "resource profits."
The Federal Court of Appeal held that the tax court judge had erred in permitting the taxpayer to amend its notice of appeal to include five new items not originally included in the notice of objection. The court of appeal stated that it was not "reasonable" to simply say that the computation of "resource allowance" or "resource profits" was in issue without specifying the particular elements of that computation. Otherwise, the court said, that level of generality would render the large corporation rules meaningless. Therefore, the taxpayer was precluded from seeking to have the reassessment vacated or varied with respect to its amended notice of appeal because of the deficiency of its notice of objection.
It is not clear, in Potash, whether the taxpayer's exclusion of the five items of income from its notice of objection was accidental or intentional. There was some suggestion by the court that some of the items were excluded for "strategic" reasons and that their exclusion was not inadvertent. Whether the exclusion was intentional or not, the court recognized that its decision was a "harsh result" for the taxpayer and a harsh rule for large corporations.
The court of appeal did leave open the question of whether the obligation to specify the relief sought in respect of each issue, expressed as the amount of change in the "undeducted outlays, expenses or other amounts" would bind a large corporation to the stated amount of relief sought and specified. The court supposed that there might be situations where an amendment to a notice of appeal could be allowed if the amendment went only to increase the quantum of a deduction and did not "entail the raising of a new issue."
The decision has far-reaching implications for many corporations. It is especially important to note that the definition of a large corporation includes a corporation that is related to a large corporation. For instance, a Canadian subsidiary of a U.S. corporation that is a large corporation could be directly affected by this decision.
1 Kaulius, et al. v. The Queen, 2003 DTC 5644.
2 Canada Trustco Mortgage Company v. The Queen, 2004 DTC 6119.
3 OSFC Holdings Ltd. v. The Queen, 2001 DTC 5471.
4 Brian J. Arnold, "The Long, Slow, Steady Demise of the General Anti-voiance Rule" (2004) vol. 52, no. 2 Canadian Tax Journal 488-511.
5 BJ Services Company Canada v. The Queen, 2004 DTC 2032.
6 Maranda v. Richer, [2003] 3 S.C.R. 193; Foster Wheeler Power Co. v. Societe Intermunicipale de Gestion et d'elimination des Deschets (SIGED) Inc., 2004] 1 S.C.R. 456; and Pritchard v. Ontario (Human Rights Commission), [2004] S.C.J. No. 16.
7 R. v. Campbell , [1999] 1 S.C.R. 565, at para. 49.
8 Potash Corporation of Saskatchewan v. The Queen, 2004 DTC 6002.