Citation: 2013 TCC 86
HER MAJESTY THE QUEEN,
REASONS FOR JUDGMENT
The Minister of
National Revenue (the "Minister") reassessed Brianne and Steven
Gwartz’s 2003, 2004 and 2005 taxation years. In the reassessments, the Minister
relied on the general anti-avoidance rule (the "GAAR") contained in
section 245 of the Income Tax Act (Canada) (the "ITA")
to recharacterize as dividends certain capital gains which had been realized by
a family trust and allocated to the appellants in 2003, 2004 and 2005. This in
turn gave rise to the imposition of the tax on "split income", provided
for in section 120.4 of the ITA, on the income recharacterized as
dividend income. The appeals were heard on common evidence.
The capital gains
allocated to the appellants were realized by a family trust after the trust
sold certain shares of a management corporation that acted for the dental
practice of the appellants’ father. These shares, which had a low paid-up
capital and a high redemption value, had been received by the family trust by
way of a stock dividend paid by the management corporation.
The appellants concede
the existence of a "tax benefit" and an "avoidance
transaction", hence the existence of "abusive tax avoidance" is
the only issue before the Court. The respondent argues that the appellants
abusively circumvented section 120.4 such that the GAAR should apply.
II. FACTUAL BACKGROUND
The parties filed an
agreed statement of facts which is summarized below.
Dr. Mark Gwartz, the
appellants’ father, is a dentist. Forest Hill Dental Management Inc. ("FHDM")
is a management corporation that acted for Dr. Gwartz’s dental practice
during the relevant period. Certain shares of FHDM were held by the Gwartz/Ludwig
Family Trust (the "Trust"), which was settled in 1994 by Dr. Gwartz’s
mother, Bernice Gwartz. The appellants were both beneficiaries of the Trust at
all relevant times, as were certain other family members.
Prior to the
transactions in issue, the Trust held all of the common shares and all of the
Class C Preferred Shares in FHDM. On December 31, 2003, FHDM issued 150,000
preferred shares of a new class, Class D, to the Trust as a stock dividend on
the common shares held by the Trust (the Class D Preferred Shares). The Class D
Preferred Shares were each redeemable and retractable for $1, but, pursuant to
the corporate resolution that authorized the payment of the stock dividend,
only $1 in total was added to the stated capital account maintained for that
class. In other words, the Class D Preferred Shares had a high redemption value
and a low paid-up capital – they were so-called "high-low" shares.
The effect of the above transaction was to shift value from the common shares
to the Class D Preferred Shares. As a result, part of the gain accrued up until
that time on the common shares held by the Trust was transferred to the Class D
On the same day, the
Trust sold 75,000 of the Class D Preferred Shares to Dr. Gwartz in exchange for
an interest-bearing promissory note in the amount of $75,000. The Trust sold
its remaining 75,000 Class D Preferred Shares to Dr. Gwartz on December 15,
2004, also in exchange for an interest-bearing promissory note in the amount of
On January 15, 2005,
FHDM issued a further 150,000 Class D Preferred Shares to the Trust, which were
each redeemable and retractable for $1, and added $1 in total to the stated
capital account maintained for that class. On January 30, 2005, the Trust sold
75,000 of the Class D Preferred Shares to Dr. Gwartz in exchange for an
interest-bearing promissory note in the amount of $75,000.
Dr. Gwartz subsequently sold his 225,000 Class D Preferred Shares
in FHDM to 2062067 Ontario Inc. (“2062067”), a corporation wholly owned by his
spouse, in return for an interest-bearing promissory note in the amount of
On February 1, 2005, FHDM redeemed
the Class D Preferred Shares held by 2062067 for $225,000. In its tax return,
2062067 reported a deemed dividend of $224,999 in respect of that redemption,
and claimed an offsetting deduction under section 112 of the ITA. The
proceeds from the redemption were used by 2062067 to extinguish its promissory
note in favour of Dr. Gwartz, and Dr. Gwartz then used the $225,000 to
extinguish his promissory notes in favour of the Trust (whose principal amounts
of the 2003, 2004 and 2005 taxation years, the Trust reported a $74,999.50
capital gain on the sale of 75,000 Class D Preferred Shares in FHDM, and
allocated those gains entirely to the appellants. In the 2003 and 2004 taxation
years, those capital gains were allocated equally between the appellants such
that each was allocated $37,499.75 in each year. In the 2005 taxation year, the
Trust allocated $24,999.83 to Steven and $49,999.67 to Brianne. The appellants
reported the capital gains allocated to them in their tax returns.
Steven Gwartz turned 17 during 2004 and Brianne Gwartz was
under the age of 17 at all material times.
The Minister, relying on the GAAR,
reassessed the appellants in respect of their 2003, 2004 and 2005 taxation
years. According to the letter explaining the reassessments, the Minister
relied on the GAAR to recharacterize the capital gains as dividend income. This
resulted in the tax on “split income” provided for in section 120.4 of the ITA
(colloquially known as the “kiddie tax”) applying to the recharacterized
(1) Evidentiary Issue: Admissibility of the CRA
A preliminary issue relates to two internal Canada
Revenue Agency (the "CRA") documents that the appellants seek to
introduce as evidence. These documents are a memorandum from the CRA’s Hamilton
Tax Services Office to the CRA’s GAAR & Technical Support Section concerning
the applicability of the GAAR (the “GAAR Committee Referral”), and a T401
Report on Objection which was prepared by the CRA in respect of Brianne
Gwartz’s Notice of Objection (the “T401”, together with the GAAR Committee
Referral, the “CRA Documents”). The respondent disclosed the CRA Documents during
the discovery process.
Counsel for the appellants argues
that the CRA Documents are relevant because they illustrate why the Minister
thought it was appropriate to apply the GAAR to the transactions in issue.
Issue: Application of the GAAR
The appellants concede that: (i) the transactions in issue
constituted a “series of transactions” within the meaning of subsection 248(10)
of the ITA; (ii) this series of transactions gave rise to “tax benefits”
as defined in subsection 245(1) of the ITA; and (iii) one or more of the
transactions forming part of the series of transactions constituted “avoidance
transactions” as that term is defined in subsection 245(3) of the ITA.
As a result, the appellants’ submissions were restricted to the issue of
whether there was a misuse or abuse of the ITA for the purposes of section
245(4) of the ITA.
The appellants rely on the
framework established in Canada Trustco Mortgage Co. v. Canada and Copthorne Holdings
Ltd. v. Canada
with respect to the possible application of subsection 245(4). The appellants
submit that the object, spirit and purpose of section 120.4 were not frustrated
by the transactions in issue. Counsel for the appellants admits that the
transactions in issue did reflect deliberate tax planning, but argues that
deliberate tax planning is not the same as abusive tax avoidance.
With respect to the text of
section 120.4, counsel suggests that the provision applies only to certain
types of persons and income. With respect to the context of section 120.4,
counsel submits that other provisions in the ITA specifically address
the extraction of corporate surplus other than by way of a dividend. For
example, counsel cites subsection 15(1.1), which, in certain circumstances, deems
the fair market value of the stock dividends, in transactions involving the
payment of stock dividends, to be included in income. Such transactions might
otherwise give rise to amounts that would be taxed on capital account. Counsel
for the appellant argues that, in light of such other specific rules contained
in the ITA, the fact that section 120.4 did not contain a specific rule
deeming certain capital transactions, such as the ones in issue, to give rise
to dividends illustrates a deliberate choice by Parliament not to extend
section 120.4 to capital gains transactions which have as one of their purposes
or results the extraction of corporate surpluses.
With respect to the purpose of
section 120.4, the appellants rely on certain extrinsic materials and similarly
conclude that Parliament made the conscious choice to enact a narrowly targeted
rule that excluded capital gains.
The appellants also submit that recent
case law supports their position. They cite McClarty Family Trust v. The
in which Angers J. held that the GAAR did not apply to transactions that were
(in the words of the appellants) “virtually identical” to those in issue in
these appeals. In particular, they note Angers J.’s comments in obiter that
it is inappropriate for the Minister to use the GAAR to fill gaps that
Parliament may have left when enacting section 120.4. The appellants cite a
passage from Lehigh Cement Limited v. Canada, in which Sharlow J.A. held
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”.
The appellants argue that the ITA
does not contain an overarching policy against surplus stripping. Counsel
for the appellants further contends that there is in the ITA no
overarching policy against income splitting either. Counsel observes that the ITA
even promotes income splitting in certain circumstances.
In addition, the appellants submit
that the transactions at issue were not artificial and did not give rise to
mere “paper losses” (or, rather, “paper gains”), as in Triad Gestco Ltd. v. The
Instead, the appellants contend that the transactions were carried out in
reliance on a well-known tax planning technique to ensure that they were
principally taxed on real taxable capital gains rather than taxable dividends.
Finally, the appellants argue that the transactions in issue
did not misuse or abuse any provisions of the ITA. The appellants submit
that the tax results of the transactions in issue are the consequence of highly
specific rules set out in the ITA, and that each of the provisions
relied upon operated exactly as intended.
(1) Evidentiary Issue:
Admissibility of the CRA Documents
Counsel for the respondent admits that the CRA Documents are
authentic. In addition, counsel consents to the T401 being admitted into
evidence for informational purposes (in counsel’s words, “the Court can look at
it and say, ‘Here is the T401’”). Indeed, counsel for the respondent referred
to the contents of the T401 during her oral submissions. Counsel for the
respondent also appears to accept that the GAAR Committee Referral would be
admissible under section 100 of the Tax Court of Canada Rules (General
Procedure) because it was disclosed as part of the discovery process. This
implies that the respondent accepts that the GAAR Committee Referral “is
otherwise admissible”, which is a condition that must be met before section 100
The respondent’s position appears to be that both of the
CRA Documents can be admitted as evidence as to the Minister’s analysis in
confirming the reassessments and deciding to apply the GAAR, but not as
evidence for the truth of their contents. Nevertheless, counsel for the respondent
also argues that the CRA Documents are hearsay, irrelevant, have no probative
value and should be given no weight.
(2) Substantive Issue:
Application of the GAAR
The respondent concedes that the reassessment in respect
of Steven’s 2005 taxation year should be vacated. Steven turned 17 during 2004
so that he was not a “specified individual”, as that term is defined in
subsection 120.4(1), during his 2005 taxation year. As a result, the respondent
acknowledges that the capital gain allocated to him in that year by the Trust
cannot be recharacterized as a dividend.
The respondent’s position is that
the Minister properly applied the GAAR because the transactions in issue (other
than those transactions relating to Steven’s 2005 taxation year) circumvented
the application of section 120.4 of the ITA in a manner that frustrated
or defeated the object, spirit or purpose of that provision. The respondent submits
that the purpose of section 120.4 is to prevent income splitting with minors. Counsel
for the respondent suggests, more specifically, that section 120.4 is targeted
at income splitting with minorswhere
those minors receive certain types of income that are susceptible to
manipulation. As support for this proposition, counsel relies on a publication
by the Department of Finance released in conjunction with the 1999 Budget,
which states: “Dividends received on any listed shares will not be subject to
these rules, since the income flow is less susceptible to manipulation”. In addition, counsel
submits that the policy underlying section 120.4 has always reflected
Parliament’s concern with income splitting involving minors where shares of
private companies are involved.
The respondent argues that capital
gains were not included in the initial version of section 120.4 because, at the
time, capital gains were not identified as the type of income that section
120.4 was designed to tax. Counsel suggests that Parliament designed the
provision to apply to then current income splitting techniques, but intended to
monitor the effectiveness of the measure and take appropriate action if new
techniques were developed. The respondent contends that Parliament did not
foresee the use of “artificial” capital gains to engage in income splitting
with minors. The use of capital gains represents an evolution of the tax‑planning
techniques used in that context.
Counsel for the respondent also argues that that the 2011
amendments to section 120.4, which, as discussed below, apply to certain
capital gains, did not reflect a change in policy. Rather, counsel argues that
the amendments reflected a move by Parliament to close a “loophole”. Counsel
compared the situation to that which was considered by the Federal Court of
Appeal in Water's Edge Village Estates (Phase II) Ltd. v. Canada. In that decision, Noël J.A.
commented that a subsequent amendment demonstrated that “Parliament moved as
quickly as it could to close the loophole”.
Counsel also noted that, in McClarty
Family Trust, Angers J. recently commented on the applicability of the GAAR
to transactions that are similar to those before the Court in these appeals. After finding that the GAAR
did not apply because of the absence of an avoidance transaction, Angers J.
stated that “[t]here is a definite gap that was left by Parliament in enacting
section 120.4 of the ITA”, and cited Landrus v. The Queen in support of the
proposition that it is inappropriate to use the GAAR to fill such gaps. Counsel for the respondent
argues that this aspect of the McClarty Family Trust decision should not
be followed, in part because it was obiter. In addition, counsel cites
the Copthorne decision (which, counsel notes, was released after the
hearing in the McClarty Family Trust case), in which, in relation to the
relevance of the principle of “implied exclusion” in the GAAR context,
Rothstein J. wrote:
. . . When the Minister invokes the GAAR, he
is conceding that the words of the statute do not cover the series of
transactions at issue. Rather, he argues that although he cannot rely on the
text of the statute, he may rely on the underlying rationale or object, spirit
and purpose of the legislation to support his position.
Finally, the respondent argues that the transactions in issue
artificially created capital gains. At the hearing, counsel argued that the
transactions in issue had the same circularity and artificiality as the
transactions at issue in Triad Gestco
and 1207192 Ontario Limited v. The Queen. Counsel suggests that the
transactions do not reflect an increase in real economic power, but merely effected
a shift of value within the family unit. Counsel also suggests that the capital
gains received by appellants were manufactured in order to convert dividends
into capital gains.
The respondent’s submissions, as
reflected in both the Written Submissions of the respondent and the oral
submissions of counsel at trial, were directed at the question of abusive
circumvention of section 120.4. However, in the respondent’s reply to the
notice of appeal in respect of each appellant it is submitted at paragraph 19
may reasonably be considered to have resulted directly or indirectly in a
misuse of a provision of the Act, including but not limited to
subsection 84(3) and sections 38, 39, 40, 82, 84 and 120.4 of the Act or
an abuse having regard to the provisions of the Act read as a whole,
within the meaning of subsection 245(4) of the Act.
addition, in the reply, the respondent submitted that the ITA, read as a
whole, is designed to prevent the extraction of corporate surplus on a tax-free
or tax-reduced basis.
At the hearing, counsel clarified that the respondent is
no longer pleading misuse or abuse of subsection 84(3) of the ITA or the
existence of an overall scheme in the ITA against surplus stripping.
IV. ISSUE TO BE DECIDED
The issue to be decided is whether
section 245 of the ITA properly applies so as to allow the
recharacterization as dividend income of the capital gains that the Trust
allocated to Brianne in her 2003, 2004 and 2005 taxation years, and to Steven
in his 2003 and 2004 taxation years (the “Relevant Capital Gains”). As
discussed above, the appellants concede the existence of “tax benefits” within
the meaning of subsection 245(1) and “avoidance transactions” within the meaning
of subsection 245(3). The applicability of the GAAR therefore turns on whether
there was “misuse” or “abuse” for the purposes of subsection 245(4).
At the hearing, I
reserved my decision on the admissibility
of, and weight that should be given to, the CRA Documents. As noted, these
documents are a memorandum to the CRA’s GAAR & Technical Support Section in
respect of the applicability of the GAAR, and a T401 report on objection which
was prepared by the CRA in respect of Brianne Gwartz’s notice of objection. Each
of the CRA Documents essentially contains a description of the facts in issue
together with an analysis of the GAAR and its applicability. The T401
additionally discusses how the transactions in issue should be treated under
the CRA’s administrative positions.
As noted above, counsel for the
respondent apparently consents to the admission of each of the CRA Documents
for informational purposes, but argues that they are hearsay, irrelevant, have
no probative value and should be given no weight.
Evidence that lacks relevance to
the matters in dispute, as framed in the pleadings, is inadmissible. In this case,
the parties have agreed on all of the material facts. Moreover, the assumptions
made by the Minister when reassessing the appellants are not in issue.
Therefore, the CRA Documents lack relevance.
(1) The Three-Step
Framework from Canada Trustco
In Canada Trustco, the Supreme Court
established a three-step framework for determining whether the GAAR applies to
a transaction or series of transactions. This framework was reasserted by the
Supreme Court in Mathew v. Canada,
Lipson v. Canada,
Within this framework, the first
step is to inquire into the existence of a “tax benefit” within the meaning of
For there to be a tax benefit, a transaction, or series of transactions of
which the transaction is a part, must result in “a reduction, avoidance or
deferral of tax or other amount . . . payable” under the ITA or
other relevant source of tax law, or “an increase in a refund of tax or other
amount” under the ITA or other relevant source of tax law. In this case,
the appellants concede the existence of a tax benefit. While there was some
debate at the hearing regarding the nature of the tax benefit conceded by the
appellants – that is whether it resulted from the avoidance of the tax imposed
by section 120.4, from the comparatively low marginal income tax rates paid by
the appellants, or from the fact that the appellants received capital gains
rather than income – the answer is ultimately unimportant because the issue was
Under the second step of the
framework established in Canada Trustco, the transaction giving rise to
the tax benefit must be an “avoidance transaction” within the meaning of
In this case, the appellants concede the existence of an avoidance transaction.
These appeals thus turn on the outcome of the third step of
the framework established in Canada Trustco, which involves a
determination whether the avoidance transaction giving rise to the tax benefit
is abusive under subsection 245(4).
Within this framework, the abuse inquiry involves, first, interpreting the
relevant provisions of the ITA to determine their object, spirit and
purpose and, second, determining whether the impugned transactions fall within,
or frustrate the purpose of those provisions.
As described in Copthorne:
order to determine whether a transaction is an abuse or misuse of the Act, a
court must first determine the “object, spirit or purpose of the provisions. . .
that are relied on for the tax benefit, having regard to the scheme of the Act,
the relevant provisions and permissible extrinsic aids” (Trustco, at
para. 55). The object, spirit or purpose of the provisions has been referred
to as the “legislative rationale that underlies specific or interrelated
provisions of the Act” (V. Krishna, The Fundamentals of Income Tax Law
(2009), at p. 818).
object, spirit or purpose can be identified by applying the same interpretive
approach employed by this Court in all questions of statutory interpretation —
a “unified textual, contextual and purposive approach” (Trustco, at
para. 47; Lipson v. Canada, 2009 SCC 1,  1 S.C.R. 3, at para. 26).
While the approach is the same as in all statutory interpretation, the analysis
seeks to determine a different aspect of the statute than in other cases. In a
traditional statutory interpretation approach the court applies the textual,
contextual and purposive analysis to determine what the words of the statute
mean. In a GAAR analysis the textual, contextual and purposive analysis is
employed to determine the object, spirit or purpose of a provision. Here the
meaning of the words of the statute may be clear enough. The search is for the
rationale that underlies the words that may not be captured by the bare meaning
of the words themselves. However, determining the rationale of the relevant
provisions of the Act should not be conflated with a value judgment of what is
right or wrong nor with theories about what tax law ought to be or ought to do.
An arrangement will be abusive if it circumvents the
application of a specific anti-avoidance rule or provision that is relied upon
in a manner that frustrates the object, spirit and purpose of the rule.
The existence of abusive tax avoidance must be clear. If
it is not, the benefit of the doubt goes to the taxpayer. Moreover, the Minister
bears the burden of establishing abusive tax avoidance.
Before undertaking the two-stage
analysis for abusive tax avoidance mandated by Canada Trustco, I will
review certain principles in relation to (i) tax planning in general, (ii) the
appropriateness of using the GAAR as a gap-filling measure, (iii) the existence
of a general policy in the ITA regarding surplus stripping, (iv) the
existence of a general policy in the ITA regarding income splitting, and
(v) the significance in a GAAR analysis of subsequent amendments to a provision
purportedly abused. All of these elements have a direct bearing on the GAAR
analysis in these appeals.
(2) Tax Planning Is Not Inherently
Canada Trustco and Copthorne
each reiterate the principle that tax planning is not per se abusive for
the purposes of subsection 245(4). In Canada Trustco, the Court stated:
proper approach to the wording of the provisions of the Income Tax Act
together with the relevant factual context of a given case achieve balance between
the need to address abusive tax avoidance while preserving certainty,
predictability and fairness in tax law so that taxpayers may manage their
affairs accordingly. Parliament intends taxpayers to take full advantage of
the provisions of the Act that confer tax benefits. Parliament did not intend
the GAAR to undermine this basic tenet of tax law.
Similarly, in Copthorne,
the Court said that “[t]axpayers are entitled to select courses of action or
enter into transactions that will minimize their tax liability”.
As a result, a taxpayer who chooses a course of action
that minimizes his or her tax liability will not necessarily have engaged in
abusive tax avoidance for the purposes of subsection 245(4).
(3) Gap Filling and the
Abusive tax avoidance cannot be found to exist if a taxpayer
can only be said to have abused some broad policy that is not itself grounded
in the provisions of the ITA. In Canada Trustco, the Court stated:
courts cannot search for an overriding policy of the Act that is not based on a
unified, textual, contextual and purposive interpretation of the specific
provisions in issue. First, such a search is incompatible with the roles of
reviewing judges. The Income Tax Act is a compendium of highly detailed
and often complex provisions. To send the courts on the search for some
overarching policy and then to use such a policy to override the wording of the
provisions of the Income Tax Act would inappropriately place the
formulation of taxation policy in the hands of the judiciary, requiring judges
to perform a task to which they are unaccustomed and for which they are not
equipped. Did Parliament intend judges to formulate taxation policies that are
not grounded in the provisions of the Act and to apply them to override the
specific provisions of the Act? Notwithstanding the interpretative challenges
that the GAAR presents, we cannot find a basis for concluding that such a
marked departure from judicial and interpretative norms was Parliament’s
to search for an overriding policy of the Income Tax Act that is not
anchored in a textual, contextual and purposive interpretation of the specific
provisions that are relied upon for the tax benefit would run counter to the
overall policy of Parliament that tax law be certain, predictable and fair, so
that taxpayers can intelligently order their affairs. Although Parliament’s
general purpose in enacting the GAAR was to preserve legitimate tax
minimization schemes while prohibiting abusive tax avoidance, Parliament must
also be taken to seek consistency, predictability and fairness in tax law.
These three latter purposes would be frustrated if the Minister and/or the
courts overrode the provisions of the Income Tax Act without any basis
in a textual, contextual and purposive interpretation of those provisions.
principle is that it is inappropriate, where the transactions do not otherwise
conflict with the object, spirit and purpose of the provisions of the ITA
to apply the GAAR to deny a tax benefit resulting from a taxpayer’s reliance on
a previously unnoticed legislative gap. This principle is illustrated in the
decision of the Federal Court of Appeal in Lehigh Cement. The Tax Court of Canada
had dismissed the taxpayer’s appeal in respect of the application of the GAAR.
Sharlow J.A., for the Federal Court of Appeal, in ruling that the GAAR did not
apply, as follows:
Parliament adds an exemption to the Income Tax Act, even one as detailed
and specific as subparagraph 212(1)(b)(vii), it cannot possibly describe
every transaction within or without the intended scope of the exemption.
Therefore, it is conceivable that a transaction may misuse a statutory
exemption comprised of one or more bright line tests such as, in this case, the
arm’s length test and the 5 year test. However, the 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. As I read Canada Trustco, the Crown must establish by
evidence and reasoned argument that the result of the impugned transaction is
inconsistent with the purpose of the exemption, determined on the basis of a
textual, contextual and purposive interpretation of the exemption.
My colleague Paris J. adopted
a similar view in Landrus:
Minister is therefore using the GAAR in this case to fill in the gaps left by
Parliament in subsection 85(5.1). This is an inappropriate use of the GAAR, as
noted by Bowman A.C.J. in Geransky v. R.:
Tax Act is a statute that is remarkable for its specificity and replete
with anti-avoidance provisions designed to counteract specific perceived
abuses. Where a taxpayer applies those provisions and manages to avoid the
pitfalls the Minister cannot say “Because you have avoided the shoals and traps
of the Act and have not carried out your commercial transaction in a
manner that maximizes your tax, I will use GAAR to fill in any gaps not covered
by the multitude of specific anti-avoidance provisions”.
Is There a Policy in the ITA
Against Surplus Stripping?
Surplus stripping involves the extraction of corporate surplus
in a manner other than by way of a dividend, usually by way of a capital gain. For
example, rather than arranging for a corporation to pay out its retained
earnings as a dividend, a shareholder might sell shares in the capital stock of
the corporation to a related corporation. Such a transaction would be
advantageous if the resulting capital gain were subject to less tax than the
dividend would have been. Surplus stripping is “[o]ne of the most longstanding
and persistent sources of conflict between taxpayers and tax collectors.”
The courts have held that surplus stripping does not inherently
constitute abusive tax avoidance. In Collins & Aikman Products Co. et
al. v. The Queen, Boyle J. wrote that:
Campbell J. in Copthorne Holdings Ltd. v. The Queen, 2007 DTC 1230,
wrote, at paragraph 73:
While the Act
contains many provisions which seek to prevent surplus stripping, the analysis
under subsection 245(4) must be firmly rooted in a unified textual, contextual
and purposive interpretation of the relevant provisions. As such, reliance on a
general policy against surplus stripping is inappropriate to establish abusive
to like effect, Lamarre J. in McMullen v. The Queen, 2007 DTC 286, wrote
at paragraph 56:
In conclusion, the
respondent has not persuaded me, or has not presented any evidence
establishing, that there was any abuse of the Act read as a whole, or that the
policy of the Act read as a whole is designed so as to necessarily tax
corporate distributions as dividends in the hands of shareholders. In any
event, as the Supreme Court of Canada has said, “[i]f the existence of abusive
tax avoidance is unclear, the benefit of the doubt goes to the taxpayer”. . .
words of Bowman C.J., Campbell J. and Lamarre J. apply equally in this case.
J. held in Copthorne that, in determining whether there has been abusive
tax avoidance, “[w]hat is not permissible is basing a finding of abuse on some
broad statement of policy, such as anti-surplus stripping, which is not
attached to the provisions at issue.”
It is also noteworthy that the respondent declined to
pursue the position, put forward in each reply to the notice of appeal, that
the appellants contravened a policy in the ITA against surplus
(5) Is There a Policy in
the ITA Against Income Splitting?
The ITA levies
an income tax on individuals at marginal tax rates that increase as taxable
income increases. Unlike the US personal income tax system, where married
couples can file joint tax returns, the Canadian income tax system requires
that couples and their children file individual tax returns in which each
family member’s tax liability generally depends on that member’s individual
The increasing marginal tax rates and the choice of the individual as the basic
taxable unit create incentives for taxpayers to split their income with their
With respect to the existence of a
policy against income splitting, the Supreme Court of Canada in Neuman v.
. . . [Subsection] 56(2) strives to prevent
tax avoidance through income splitting; however, it is a specific tax avoidance
provision and not a general provision against income splitting. In fact, “there
is no general scheme to prevent income splitting” in the ITA (V. Krishna
and J. A. Van Duzer, “Corporate Share Capital Structures and Income Splitting: McClurg
v. Canada” (1992-93), 21 Can. Bus. L.J. 335, at p. 367).
Section 56(2) can only operate to prevent income splitting where the four
preconditions to its application are specifically met.
case concerns income received by Ruby Neuman during the 1982 taxation year at
which time the ITA did not provide specific guidelines to deal with
corporate structures designed for the purposes of income splitting and tax
minimization. Professor V. Krishna, in an article entitled “Share Capital
Structure of Closely-Held Private Corporations” (1996), 7 Can. Curr. Tax 7, at p. 9, made the following comment with respect to income
splitting in the corporate context:
specifically curtailed by the Income Tax Act (for example, by the
attribution rules), income splitting per se is not a sanctioned
arrangement. Thus, corporate structures that facilitate income splitting in
private companies should not be penalized without clear statutory language and
While Neuman predates the enactment of subsection 120.4, a broad
policy in the ITA against income splitting, grounded in specific
provisions of the ITA other than subsection 120.4, has not been
(6) The Significance of Subsequent Amendments
The courts have taken differing approaches when considering the
significance of subsequent amendments as an indicator of the policy underlying
previous versions of a provision. In Water’s Edge, the Federal Court
of Appeal dismissed in the following terms the appellant’s argument that the enacting
of a subsequent amendment confirmed that the GAAR did not apply previously as
for the appellants relied on the subsequent addition of subsection 96(8) to the
Act. . . to argue that the transactions in issue do not offend any
unwritten rule or policy. Subsection 96(8) was added by S.C. 1994, c. 21. . . and
made applicable after December 21, 1992. Paragraph 96(8)(a) is of direct
relevance. It specifically counters the result achieved by the appellants in
this case by deeming the cost of acquisition of depreciable assets held by a
foreign partnership to an incoming Canadian partner to be the lesser of its
fair market value or its capital cost determined according to the ordinary
argued that the prospective addition of subsection 96(8) demonstrates
unequivocally that the transactions in issue did not offend the object and
spirit of the Act at the time when they took place. I rather think that this
amendment demonstrates that Parliament moved as quickly as it could to close
the loophole exploited by the appellants precisely because the result achieved
was anomalous having regard to the object and spirit of the relevant provisions
of the Act.
Ultimately, the Federal Court upheld the Tax Court of
Canada’s decision that the losses claimed by the appellants were properly
denied by virtue of the GAAR.
In contrast, one of the issues in
each of Triad Gestco and 1207192 related to the Minister’s
argument that the anti-avoidance rules in subparagraph 40(2)(g)(i) had
been abusively circumvented.
Subparagraph 40(2)(g)(i) is a “stop-loss” rule that can operate to deny
a capital loss that is generated on a transaction between “affiliated persons”.
The definition of “affiliated persons” in section 251.1 had been amended,
effective after the impugned transactions took place. In Triad Gestco,
Noël J.A. wrote:
agree with Justice Paris that a reading of the relevant provisions does not
support the existence of the policy identified by the Tax Court judge
essentially for the reasons that he gave. When Parliament introduced the notion
of “affiliated persons” back in 1995, it had to be aware that trusts could be
used to counter the operation of subparagraph 40(2)(g)(i) and subsection
40(3.4). It is therefore reasonable to infer that a deliberate choice was made
not to bring trusts within the definition. The fact that Parliament decided
to alter this policy by including trusts on a prospective basis in 2005 cannot
be relied on to infer that a policy to that effect was in place before the
amendment (compare Water’s Edge Water’s Edge [sic]Village
Estates (Phase II) Ltd. v. Canada, 2002 FCA 291,  2 F.C. 25, para.
47, where in contrast an amendment was held to be relevant because it had been
enacted in order to close a blatant loophole).
Paris J., in his reasons in 1207192, referred to by Noël
J.A. in Triad Gestco, wrote:
definition of “affiliated persons” in section 251.1 as it read for the year in
issue sets out a carefully crafted group of relationships, and I believe that
it is reasonable to infer that Parliament chose to limit the scope of the
. . .
held, though, that the amendments in Landrus did not “alter the fact
that the stop-loss rules were exceptions that operate in well-defined circumstances”
and that even after the amendments they did not deny losses on all transfers
between all related parties. Therefore, the amendments were not material to the
determination of the policy underlying the stop-loss rules in effect for the
year under appeal.
Those decisions demonstrate that a subsequent amendment,
which would have defeated a tax avoidance strategy challenged under the GAAR,
does not in itself indicate either that the strategy was abusive or that it was
non-abusive. Instead, the subsequent amendment must be considered along with
all other relevant materials to ascertain the object, spirit and purpose of the
provision. In certain circumstances, a subsequent amendment might suggest that
the provision’s object, spirit and purpose were frustrated by the tax avoidance
strategy. In other circumstances, it might suggest that Parliament simply
changed its mind and now intends to prevent something that initially was not
intended to be captured by the provision.
(7) Do the
Impugned Transactions Frustrate the Object Spirit and Purpose of Section 120.4?
(a) Text of Section
fact that the wording of section 120.4 does not apply to the transactions in
issue, that wording can shed light on the intent underlying the provision.
Compared with other provisions in the ITA, the text of
section 120.4 is notable for its relative brevity and simplicity. Its applicability
or non-applicability to a transaction is, in general, readily observable. For
example, determining whether a person is a specified individual, or determining
whether certain dividend income received directly by a specified individual is
split income, is straightforward. These factors suggest that, when enacting
section 120.4, Parliament was concerned with minimizing the complexity of the
provision and providing certainty to taxpayers with respect to its application.
of Section 120.4
In the ITA, certain provisions serve to eliminate the tax advantages that can be
obtained using certain income-splitting techniques. For example, the attribution rules contained in subsections 74.1(1)
and (2) of the ITA can serve to negate the tax advantages of transferring
an income-generating property to a family member. As the respondent notes,
similar measures can be traced back to the Income War Tax Act, 1917. Similarly, subsections
56(2) to (4) serve to regulate certain transactions by which income is diverted
from an individual to the individual’s spouse.
However, certain provisions in the
ITA also encourage or facilitate some arrangements that arguably
constitute income splitting. For example, under subsection 146(5.1), a taxpayer
is entitled to a deduction in respect of a contribution to a spouse’s
registered retirement savings plan. Similarly, by virtue of subsections 146.1(5)
and (6), the income generated within a child’s registered education savings
plan is generally payable in respect of (in the hands of either the child or
the contributor). Additionally, a taxpayer can generally transfer capital
property to his or her spouse on a tax-deferred basis under subsection 73(1)
(although any income generated by the property or any resulting capital gain
will generally be attributed back to the transferor pursuant to section 74.1 or
Another relevant contextual feature of the ITA relates
to the practice of surplus-stripping and the provisions of the ITA that
address it. There are multiple provisions in the ITA that can serve to
eliminate the tax advantages of certain surplus stripping transactions. The
appellants cite sections 84 and 84.1 of the ITA, which deem certain
transactions, which might not be viewed as dividend transactions under
corporate law, to give rise to dividends for the purposes of the ITA.
For example, subsection 84(3) will generally deem a corporation to have paid a
dividend where the corporation has redeemed, acquired or cancelled any of the
shares of its capital stock and the amount paid by the corporation exceeds the
paid‑up capital of the shares redeemed, acquired or cancelled.
Similarly, section 84.1 aims at
precluding the stripping of corporate surpluses where shares are sold in non-arm’s
length transfers implemented through transaction steps similar to those under
scrutiny in these appeals. In very general terms, section 84.1 prevents
individuals from extracting corporate surpluses by, inter alia,
triggering capital gains in respect of which a capital gains exemption is
claimed under section 110.6. The amount of corporate surplus extracted directly
or indirectly by a non-arm’s length party through the use of a capital gains
exemption is deemed to be a dividend. For example, assuming that common shares
of FHDM were qualified small business shares in that they were shares of a
small business corporation as defined in the ITA, section 84.1 could
have applied if the trust had sold common shares and the appellants had been
entitled to claim, and did in fact claim a capital gains exemption under
section 110.6 in respect of the capital gains allocated to them.
Section 212.1 of the ITA
operates in a similar fashion where a non-resident of Canada seeks to extract
corporate surpluses by, inter alia, triggering directly or indirectly a capital
gain that is, in most cases, exempt from tax by virtue of an applicable tax
The fact that specific
anti-avoidance provisions were enacted long before the introduction of section
120.4 leads me to infer that Parliament was well aware of the fact that
taxpayers could arrange to distribute corporate surpluses in the form of
taxable dividends or of capital gains subject to the application of those
specific anti‑avoidance provisions. The fact that those provisions were
not amended and that a specific rule was not included in section 120.4 to curtail
well-known techniques leads me to infer that Parliament preferred simplicity
over complexity when it enacted section 120.4. This militates against a finding
that section 120.4 is indicative of a general policy in the ITA against
surplus stripping implemented with the help of non-arm’s length parties.
The appellants also cite section
15 of the ITA, which can deem certain capital transactions between a
corporation and a shareholder (i.e., section 15 benefits) to be on account of
income. For example, subsection 15(1.1) can require a shareholder to recognize
an income inclusion equal to the fair market value of a stock dividend in
circumstances where “it may reasonably be considered that one of the purposes
of [the] payment [of a stock dividend] was to significantly alter the value of
the interest of any specified shareholder of the corporation”. Certain section
15 benefits are specifically included in the definition of “split income”
contained in subsection 120.4(1). I surmise that the respondent did not invoke
this provision in the instant case because value was shifted from shares owned
by the Trust to other shares owned by the Trust rather than from one taxpayer
The context of section
120.4 demonstrates that Parliament has
implemented many measures within the framework of the ITA to reduce the
effectiveness of surplus stripping. This contrasts with the respondent’s
submission that Parliament did not foresee the use of capital gains transactions
to strip corporate surpluses when enacting section 120.4. The existence of the
above-mentioned specific measures suggests that, when enacting section 120.4,
Parliament was well aware of the practice.
(i) 1999 Budget, Supplementary Information
It is well established that budget materials are
appropriate extrinsic materials to consider when engaging in a purposive
interpretation of a provision of the ITA. In this case, there are
certain extrinsic materials that are relevant. In 1999, the Department of
Finance published a document entitled The Budget Plan 1999, Including
Supplementary Information and Notices of Ways and Means Motions (February
16, 1999) (the “1999 BSI”), which contained the following commentary on the draft
version of section 120.4:
In order to
improve the fairness and integrity of the Canadian tax system, this budget
proposes a targeted measure to discourage income splitting with minor children.
The new measure constitutes a special tax, at the top marginal tax rate instead
of the normal graduated rates, to be imposed on certain income of individuals
age 17 or under.
Income that is
not received as dividend income, partnership income or trust income is not
subject to the new measure. Accordingly, income from employment or personal
services of the minor will not be subject to this measure. Dividends received
on any listed shares will not be subject to these rules, since the income flow
is less susceptible to manipulation. Further, income from property acquired on
the death of a parent of the individual will be exempt from the measure, as
will income from any property inherited by individuals with disabilities who
are eligible to claim the disability tax credit or by individuals who are in
full time attendance at a post-secondary institution. Individuals who have no
parent resident in Canada for tax purposes in the year will also be exempted
from the application of the new tax.
The scope of
this new measure is narrow; it targets those structures that are primarily put
in place to facilitate income splitting with minors. The government will
monitor the effectiveness of this targeted measure, and may take appropriate
action if new income-splitting techniques develop.
The respondent cites these comments from the 1999 BSI in
support of the proposition that Parliament intended section 120.4 to prevent
income splitting achieved through the use of forms of income that are
susceptible to manipulation. The respondent relies on the Department of
Finance’s reference to the fact that dividends on listed shares are to be
excluded from the tax on split income because they are less susceptible to
manipulation. However, the fact that it may have excluded certain types of
income because they are less susceptible to manipulation does not mean that it
intended to include all forms of income that are susceptible to manipulation.
Moreover, the comments in the 1999 BSI suggest that, in enacting section 120.4,
Parliament did not intend it to be a broad provision dealing with all types of
income splitting with minors. The Department of Finance stated that the
proposed measure would only apply to dividend income, partnership income or trust
income, and emphasized that the provision is “narrow” and “targeted”.
(ii) Subsequent Amendments to Section 120.4
As discussed above, subsequent amendments to a provision,
may, in limited circumstances, be a relevant consideration when examining the
policy underlying the former version of the provision.
In 2011, section 120.4 was amended
to add new subsections 120.4(4) and (5), which are applicable to dispositions
occurring after March 21, 2011. In general terms, these new subsections operate to deem a specified individual who has
received certain capital gains, either directly or through a trust, to have
received non-eligible, taxable dividends for the purposes of the ITA
(including subsection 120.4(2)). Subsection 120.4(4) generally applies where a
specified individual realizes a capital gain on the disposition of shares of a
private corporation to a person with whom the individual does not deal at arms length.
Subsection 120.4(5) generally applies where a specified individual would be
required to recognize trust income that can reasonably be considered to be
attributable to a capital gain realized on the disposition of shares of a
private corporation to a person with whom the specified individual does not
deal at arms length. It would appear that, had the 2011 amendment to section
120.4 been in force when the transactions in issue were carried out, the Relevant
Capital Gains would, by virtue of subsection 120.4(5), have given rise to tax
under subsection 120.4(2).
In conjunction with the proposal to amend section 120.4 by
the addition of subsections 120.4(4) and (5), as described above, the
Department of Finance released a document entitled Tax Measures:
Supplementary Information and Notices of Ways and Means Motions (June 6,
2011). In that document, the Department of Finance made the following comments
about the proposal (at page 287):
tax on split income did not initially apply to capital gains because the
planning techniques that were being used at the time did not rely on capital
gains to split income with a minor. However, income-splitting techniques have
been developed that use capital gains to avoid the tax on split income. These
techniques involve capital gains being realized for the benefit of a minor on a
disposition of shares of a corporation to a person who does not deal at arm’s
length with the minor.
2011 proposes a targeted measure to maintain the integrity of the tax on split
income regime. The measure will extend the tax on split income to capital gains
realized by, or included in the income of, a minor from a disposition of shares
of a corporation to a person who does not deal at arm’s length with the minor,
if taxable dividends on the shares would have been subject to the tax on split
income. Capital gains that are subject to this measure will be treated as
dividends and, therefore, will not benefit from capital gains inclusion rates
nor qualify for the lifetime capital gains exemption.
measure will apply to capital gains realized on or after March 22, 2011. In addition,
the government will continue to monitor the effectiveness of the tax on split
income regime and will take appropriate action if new income-splitting
These comments suggest that Parliament’s intention in
amending section 120.4 was to broaden the scope of the provision. The
Department of Finance notes that the measure will “extend” the tax on split
income. There is no suggestion that the provision had as its purpose the
prevention of all income splitting with minors. Indeed, the Department of
Finance suggests that the amendment is itself a “targeted measure”.
It is also noteworthy that the
amendment extends the so-called kiddie tax to a broader subset of capital gains
transactions. The amendment includes capital gains realized on the disposition
of non-listed shares by specified individuals regardless whether the
transactions include or not a corporate-surplus-stripping purpose or result
such as that alleged in the instant case. In my opinion, a reasonable inference
can be drawn that Parliament decided not to cover capital gains when the
measure was first enacted, and chose to do so on a prospective basis only with
respect to a narrow subset of capital gains transactions.
Contrary to the submissions of the
respondent, the manner in which the 2011 amendment was proposed and enacted does
not suggest that Parliament was closing a loophole as described in Water’s
In this case, Parliament moved to prevent a tax-planning strategy approximately
ten years after that strategy was first outlined publicly. To paraphrase Nöel J.A.’s
comments in Triad Gestco, when Parliament introduced section 120.4 it
had to be aware that capital gains could be used to counter its operation.
The respondent, in her
written submissions, argues that the appellants succeeded in creating and
triggering artificial capital gains by using high-low dividends, as follows:
this case, the appellants undertook transactions designed to create and trigger
a capital gain at their choosing and timing through the high-low stock dividend
"amount" of a stock dividend is defined in subsection 248(1) as generally
the amount by which the paid-up capital of the corporation that paid the
dividend is increased by reason of the payment of the dividend. Likewise, the
adjusted cost base of the shares issued on the stock dividend is defined in
subsection 52(3) as the same amount. In this case, the stock dividend was
purposely set low and the fair market value purposely set high such that the
amount of the dividend to the Trust under section 82 was negligible and the
created pregnant gain could be deferred to a time of the taxpayer’s choosing.
The creation of the high-low stock dividend simply transferred the existing
value in FHDM to the minor children.
trust then sold the shares to the father who in turn sold the shares to a
non-arm’s length corporation. The dispositions and the capital gains were
spread over three years to secure the lowest tax rate and the redemption was of
the corporation’s shares so as to access the section 112 dividend deduction.
The minor children were allocated the funds through exchanged notes. Not too
dissimilar transactions were also in play, but for a different result in Triad
Gestco and two other recent "value shift" cases from the Federal
Court of Appeal.
Here, the transactions were designed to circumvent subsection 120.4 through the
creation and manipulation of a capital gain.
Counsel for the respondent
suggests that the transactions in issue have the same circularity and
artificiality as the transactions at issue in Triad Gestco and 1207192,
and that the transactions in issue similarly did not reflect an increase in
real economic power. With respect, this argument is a red herring.
While the transactions in Triad
Gestco and 1207192, like the transactions in issue in these appeals,
relied upon high-low shares, the similarity appears to end there. In this case,
a capital gain had accrued on the common shares. The appellants did not need to
resort to the payment of a stock dividend to trigger a capital gain. The Trust
could have realized the same capital gain by selling the appropriate number of common
shares of FHDM to trigger the targeted capital gain and by allocating the
resulting gain to the appellants. The stock dividend did not create a capital
gain as contended by the respondent. All that the stock dividend achieved was
to transfer part of the accrued gain on the common shares to the Class D
Preferred Shares. I suspect that this was done in order to dispense with a valuation
of the common shares, which would have been required had the transaction
proceeded instead through a sale by the Trust of some of the common shares of
FHDM. A valuation was not required for the Class D Preferred Shares because
their redemption price was fixed and the residual value of FHDM accrues to its
common shares. Whereas in Triad Gestco and 1207192 the taxpayers
created artificial capital losses to shelter true economic capital gains, the
appellants in this case paid tax on their capital gains. Moreover, the
respondent’s concession with respect to the capital gain recognized by Steven
for his 2005 taxation year is inconsistent with the position that the Relevant
Capital Gains were artificial. There is no principled distinction in this
regard between the Relevant Capital Gains and the capital gain recognized by Steven
for his 2005 taxation year.
For all of the reasons noted
above, I am of the opinion that the transactions giving rise to the Relevant
Capital Gains did not circumvent the application of section 120.4 in a manner
that constituted abusive tax avoidance for the purposes of subsection 245(4). At
the very least, the respondent did not establish that the transactions violated
subsection 245(4). Therefore the appeals are allowed and the assessments are
Signed at Calgary, Alberta, this 1st day of May 2013.
"Robert J. Hogan"