17 May 2023 IFA Finance Update
This provides summaries of oral remarks provided by Trevor McGowan (Associate Assistant Deputy Minister, Tax Policy Branch, Finance Canada) at the IFA Canada annual conference in Calgary on 17 May 2023 for some of the topics covered by him. These topics included changes to the GAAR rule discussed in the August 11, 2022 consultation paper and the draft GAAR amendments released with the federal budget materials on March 28, 2023, including response to specific questions summarized below. The moderators were Laura Gheorghiu (Gowling) and Drew Morier (Osler).
Q: Budget 2023 confirmed Canada’s intention to introduce legislation implementing the income-inclusion rule and a domestic minimum top-up tax in early 2024, and an under-taxed profits rule starting in 2025. What progress has Canada and other countries made on these points?
A: Pillar 2 is the multilateral framework agreed to by 138 countries for a global minimum tax that would ensure that large multinational corporations (i.e., with at least €750 million of annual revenues) are subject to an effective tax rate of at least 15% in jurisdictions where they operate.
Budget 2023 announced a proposal to implement the primary Pillar 2 rule, known as the “income inclusion rule” or IIR, effective for fiscal years of multinational groups that began on or after December 31st, 2023 (consistent with Canada’s commitment to have something “in 2023,” if only by one day.)
The government has also announced a domestic minimum top-up tax, also effective in 2024, which would apply to Canadian members of multinational groups that are within the scope of Pillar 2. This would essentially allow Canada to collect the top-up tax in respect of any low-tax income of such Canadian entities that would otherwise be collected by other countries under their respective Pillar 2 rules.
The government further proposed to implement the backstop rule of Pillar 2, also known as the “under-taxed profits rule” or UTPR, effective in 2025.
The proposed effective dates for Canada’s Pillar 2 legislation are generally in line with peer countries, with a number of key countries having announced their intention to implement Pillar 2. It seems increasingly certain that critical mass on the project will be achieved.
As noted in the Budget, the government is aiming to release draft implementing legislation for the IIR and domestic minimum top-up tax in the coming months, with draft legislation for the UTPR to follow next year. There is a team working flat-out on this project, with additional resources having been pulled in.
Canada’s implementing legislation will need to adhere very closely to the Pillar 2 model rules, commentary and administrative guidance published by the OECD, in order for Canada’s rules to be recognized by other countries as “qualified rules,” so that they respect Canada’s primary right to tax in accordance with the Pillar 2 framework. That said, there will be differences, largely related to Canadian drafting conventions and compatibility with domestic legislation – but it is very important that the model rules be closely followed.
Canada’s legislation will include the transitional safe harbours that were agreed to by the inclusive framework countries and published by the OECD last December. These safe harbours allow the use of data contained in country-by-country reports in appropriate cases for purposes of the effective tax-rate computations under Pillar 2, and are expected to meaningfully reduce compliance burdens.
Regarding Canada’s intention to closely align with the OECD model rules, it has announced that there will be peer-reviews – the other inclusive framework countries will assess an implementing countries’ Pillar 2 legislation against the model rules, commentary and administrative guidance. The government intends to submit Canada’ draft legislation for peer review soon after it is publicly released, with a view to securing “qualified" status for Canada’s legislation, thus giving taxpayers certainty as to which countries’ rules will apply before the rules come into effect.
The Department officials continue to develop further administrative guidance through the OECD on key remaining issues, and the OECD has indicated that it will release new administrative guidance on these and other issues on a rolling basis, as and when they are agreed to by the conclusive framework, in recognition of the importance for taxpayers and implementing countries receiving this guidance as soon as possible.
Consultation on Transfer-Pricing Rules
Q: Last year, Finance indicated that there was a fairly advanced draft on changes to the transfer pricing rules. Can Finance provide an update?
A: Finance is hoping to get this out as soon as it can, but has nothing to announce at this point.
Mandatory Disclosure Rules
A: Does Finance have any remarks on the interaction between the mandatory disclosure rules and the GAAR proposals?
A: The convergence between the two was absolutely part of the Department’s thinking. At one point, the Department was internally considering whether the MDR and GAAR proposals and paper should be folded into the release. We decided against that for a number of reasons. One was the more mature state of the MDR proposals (which came out of the BEPS plan); another was a difference in philosophical approaches between the two.
The GAAR consultation paper was intended to be at a more preliminary, consultative stage, whereas for some of the MDR proposals, Finance had a fairly clear idea of where it was headed, and that it was going to be consistent with the BEPS action report, and it was not a good thematic match with the GAAR paper.
That’s also the reason that we pulled out the tax attributes measure from the GAAR consultation – again, we basically knew what we wanted to do with that, and had a proposal ready. We were not looking for the same kind of public engagement as with the GAAR paper.
We had developed them in concert, knowing that the MDR proposals addressed the last concern in the GAAR consultation paper – namely, whether GAAR is an effective deterrent for aggressive tax planning. Of course, the extent to which disclosure is made, and CRA is able to identify and analyze tax planning structures through the MDR rules, that could help address that issue raised in the GAAR paper. That also ties into there being an exclusion for transactions that have been disclosed from the extended reassessment period and things like that.
It is absolutely correct that they tie into one another and were partly developed in concert internally, and that is why you see some of the convergence.
Proposed GAAR Changes
Q: The consultation paper and the proposed amendments to the GAAR appear to represent a solution in search of a problem – the jurisprudence is fairly well established, and major amendments would upend that stability. What about the current state of the GAAR does the government take issue with?
A: It provides useful context to first discuss the Department of Finance mandate and how it develops proposals. Recalling previous conferences, there are some misunderstandings regarding what the Department does, and its role in the development of tax policy.
First, we work for the Minister of Finance. My references to the “Department” are to the civil service, whereas my references to the “government” generally refer to the elected government, as in: “in the last election, the Liberals formed the government.” For example, a reference to "the government announcing its intention to table legislation" is to elected members of Parliament, whereas a reference to "the Department working with its OECD counterparts" is to us.
We work for the Minister of Finance and the government generally, and we have a number of different sources for our proposed amendments. Some are internally generated, some come from suggestions from CRA. Many come from letters from the community and we have made recent efforts to try to get more and more of those legislated. We also receive policy guidance from the elected government.
The GAAR was part of the government’s last election platform. It stated that it would modernize the GAAR, including by adding an economic substance component, and that was part of the Prime Minister’s mandate letter to the Minister of Finance to update the GAAR, including through the introduction of an economic substance component. That was publicly out there, as part of what was voted on, and informed part of the government’s mandate.
With that said, the Department then took that direction and analyzed the GAAR to determine what needs to be updated. As noted in the consultation paper, the GAAR has been a reasonably effective tool for combatting aggressive tax avoidance. However, we identified a number of issues – some of which were not borne out by the data and have been dropped. Each section of the paper has a “Statement of Issue” subheading that specifies the problem meant to be addressed. The idea was not to overturn the whole system, but to provide some tweaks where needed that we thought would be effective.
One subtle point: you will notice that for the first issue, “Tax benefit”, there were no recommended proposals. Some of the other ones stated the issue (e.g., failure to provide an effective deterrent in many cases for aggressive tax planning, interpretive difficulties, and difficulties in applying specific tests). We set out those issues to be addressed, along with various possible approaches to dealing with them.
As noted in the paper, the intention was not do all of the proposals – indeed, some of them were mutually exclusive. An exception in this regard is the introduction of an economic substance component. That was part of the Minister’s public mandate, so it would have been disingenuous for us to state that we “might” make such a change, or were just “considering” it. That is why the framing in that case was as to “how are we going to introduce an economic substance component” so that the GAAR would not be upended, and so that we would just nudge it or improve it as needed without throwing out 30 years of caselaw.
I think that the consultation itself was successful. We got comments and submissions from an unusually wide variety of sources. Usually, when we put out legislative proposals, we get comments from the specialist tax community. The GAAR consultation generated comments from practitioners and businesses as expected, but also from civil society groups and academics and individuals arguing in their own capacity. There was a much broader range of opinions, ranging from “do whatever is the least you can do,” all the way to “tax advisors who engage or advise in aggressive tax planning and transactions subject to the GAAR should probably lose their licences.” You will see from the proposals that we did not land on either extreme! We went through each submission and came up with what we thought was a balanced set of proposals for updating the GAAR.
You asked about the genesis behind the GAAR update. I mentioned it being part of the mandate. I do not mean to say that “we’re following orders.” There were some issues on the economic substance front that we thought were appropriate to address.
As for the caselaw, the big one is Canada Trustco, in which economic substance was not terribly persuasive. After that decision, there was a major decrease in cases with arguments about economic substance – it just did not come up anymore, even though it was an important consideration. We have rules in the Act that do various things: they compute how much tax we should pay, based mainly on active economic activity. And we have other rules that establish tax expenditures and credits. It is important that you really do what is being incentivized.
In other words, economic reality was considered to be quite important. There of course were various proposals about how to do that, set out in various aspects of the tests we were designing. That part of the paper is really Finance saying “we’ve got this problem – which tests, and which elements of those tests, would you prefer? How would you help design it?”
Part of the thinking in the GAAR consultation paper was that we should bring stakeholders in a step or two earlier in the consultation process. Usually, when Finance brings measures or consultations to the public, the Department officials will develop recommendations internally and bring them to the Minister, the Minister decides to put those recommendations out for consultation, Finance identifies specific issues to the public and canvasses solutions to those issues, and then Finance puts out its recommendations, ideally with draft legislation.
The GAAR consultation paper goes one step earlier in the process. We put it out to the tax community saying “here are the issues, let’s do the analysis together; let’s talk about what is the best way to address them”, rather than “here’s our proposal, tell us if we missed a comma.” Based on the level of engagement we have seen, I think this approach has been a success.
Bringing all of that back to the economic substance measure, we did get some comments on how to do it, whether it should be an interpretative approach or an “if A, then B”-type rule - split evenly down the side. And in terms of how to properly test for economic substance, I think the prevailing comment was, “gee that seems hard—good luck!” The general preference was to combine multiple factors, which is what can be seen in the draft provision.
We took those comments, and drafted some legislative proposals as part of the Budget package, that took into account feedback from practitioners. I think it is safe to say that the economic substance test did not land quite where I expected exactly in terms of design, and the proposals were the result of a collaborative effort.
As for “lessons learned” from this project, I think bringing people in a little earlier can sometimes be an effective way to attract a diversity of viewpoints. Obviously, we greatly appreciate practitioners’ views, especially their eye for detail, but getting a broader source of comments has been productive.
In summary, the idea was not to completely rewrite everything, and to take a collaborative effort, bringing people into the process earlier.
Insertion of Preamble
Q: The use of a preamble in the proposed GAAR amendments is novel in Canadian tax legislation. Does Finance anticipate using this approach in the future?
A: Of course, preambles are not unheard of in Canada. The Greenhouse Gas Pollution Pricing Act – famously “not a tax” – has a preamble. You see them in different contexts; just not in the Income Tax Act.
One of the options floated for how we could provide additional certainty in the income tax interpretation is by introducing preambles. Adding preambles to the Act retrospectively would be a massive undertaking – how do you drill down to write a preamble for a section that has a broad design, exclusions, and sub-exclusions to the exclusions?
For new proposals, or for significant revisions to existing provisions, we might consider preambles in the future, depending partly on how this one goes.
Paragraph (a) of the Preamble
Q: Paragraph (a) of the preamble states that taxpayers should be allowed to “obtain tax benefits contemplated by the relevant provisions.” How would one establish whether a tax benefit is contemplated, and who has the onus?
A: Most tax rules establish a syllogistic system of “if A and B, then C; if C and D then E.” You work through the rules on paper, ticking off all the conditions, and arrive at a result. The GAAR requires a more broad interpretive approach, and a preamble helps set out the purpose or ideas underlying the GAAR. We’re not adding an “X” into a specific stage of the taxation framework. The preamble is more intended to provide context and a statement of purpose so that, when you are performing your contextual, contextual and purposive analysis, the preamble is an additional tool to inform that analysis.
There have also been some comments from the judiciary to the effect of “what is the GAAR really about,” and the preamble attempts to speak to that as well.
Finance has been considering the difference between putting statements of purpose in the technical notes or in the legislation as a preamble under the GAAR. The first two paragraphs in s. 245(0.1) were restatements of those made contemporaneously with the introduction of the GAAR. The first reflects a statement made in, I believe, the whitepaper, that taxpayers should of course be allowed to receive benefits intended by Parliament. The GAAR would be a silly rule if Parliament enacted RRSPs, and then the GAAR blocked RRSP deductions. Part of the idea behind it was moving some of these statements of purpose into the legislation to see what effect that would have on judicial interpretation of the ideas.
In summary, the preamble is not meant to affect GAAR analysis in a syllogistic “if A then B” way, but it is meant to colour the reading.
Q: Given that most GAAR cases turn mainly on the “misuse or abuse” analysis, what is motivating the push to lower the bar for determining whether a transaction is an “avoidance transaction?”
A: That change is meant to deal with the issue of mixed-purpose transactions. A transaction generally will not be under consideration where you can clearly say “that is a 100% tax-motivated transaction,” or “that is a 100% commercial transaction” because, of course, commercial transactions inherently have a tax dimension to them. Where transactions are close to the line and it is tough to determine what the primary purpose is, that can lead to some outcomes which we consider to be inappropriate.
We have seen suggestions in obiter dicta that, if there is a transaction that secured a foreign tax benefit of $60 and a Canadian tax benefit of $40, maybe that is not primarily an avoidance transaction; but if the exchange rates change and you did the exact same transaction again so that the Canadian tax benefit were larger, that would then be an avoidance transaction. We considered adding “avoidance of foreign tax” to the test, but ultimately concluded that adjusting the avoidance transaction test to “one of the main purposes” would ensure a better balance.
The test should still have a gatekeeping function – avoidance still has to be one of the “main” purposes – before getting to the “misuse or abuse” analysis, but I think this represents a more modern approach to avoidance transaction rules, and gets around some of that analytical uncertainty in situations where there are multiple purposes, leading to an artificial exercise in picking the “winner” from among those purposes.
Q: What role is the presence or absence of economic substance intended to have in the textual, contextual, and purposive interpretation undertaken as part of the “misuse or abuse” analysis?
A: Mechanically, economic substance is an add-on to the “misuse or abuse” analysis, responding in part to the question “what relevance does economic substance, or lack of substance, have on the GAAR analysis. It indicates that when doing the “misuse or abuse” analysis, if there is a transaction that is significantly lacking in economic substance, that will tend to show abuse.
There will, of course, be cases where that is not true – the Budget materials mention moving something from a taxable account to a TFSA. The tax rules would not make much sense if you did not allow for that sort of transaction, notwithstanding its lack of economic substance. The provision is intended to add context and more information on how to deal with economic substance in the context of the misuse or abuse analysis in s. 245(4).
The provision refers to the lack of economic substance, rather than what is the substance. For example, it is not saying that, if there is a transaction that is, legally, a sale and repurchase of an asset, but substantively it is clearly a financing arrangement, that the mismatch between form and substance is itself a problem. What matters is a lack of substance - i.e., is something really going on here? Is it just a circular flow of funds with no change in anybody’s economic position? Do you just walk around a boardroom table signing a bunch of documents, and nothing has really happened other than tax-savings, to focus on the starkest example? The question certainly is not “is the legal form of the transaction tracking what it should be considered economically” – we’re not upending the Canadian tradition of focusing on legal form.
Perhaps a straight deeming rule could have expressed the idea more clearly, but that seemed a bit tough. Conversely, a pure interpretation rule (i.e., “maybe think about economic substance” when considering abuse or misuse) did not seem to provide enough direction, especially in light of some of the comments we have seen in cases. Instead, we have tried to find a middle ground.
Q: How can you determine whether an arrangement lacks economic substance without inquiring into what the economic substance of the transaction actually is?
A: You would want to know what the economic substance of the transaction is, but that is not determinative. If there is a mismatch between the economic substance and the legal characterization, but it is a real transaction in the sense that it has an economic impact, then it is okay.
The mismatch between the economic characterization and the legal characterization of the transaction is not what being tested – it’s a lack of substance. There are three paragraphs providing three different factors, no one of which will be dispositive in every case, and depending on the circumstances some may be more relevant than others – rather like the employee vs. independent contractor test. You examine things like “has your economic position changed?”
When we use the phrase “economic position” in the Act, we are often referring to an economic opportunity for making profit or a risk of loss – has that changed? Has there been any effect on the potential for profit? Other things to look for are a circular looping of funds, or whether a transaction is entirely tax-motivated. These are not testing the economic reality of a transaction so much as invoking the axiom that “where there’s smoke, there’s fire.”
Rationale for Penalties
Q: Given that GAAR only matters in situations where a taxpayer has complied with the provisions in question, what is the rationale for the application of penalties in all cases where GAAR reassessment is successful, absent disclosure? Is there a reason that a due diligence defence is unavailable?
A: The introduction of a penalty is a response to the issue raised in the consultation paper that the GAAR was not an adequate deterrent for a lot of aggressive tax-avoidance. The thought was that, by adding a penalty, that changes the economic calculus as to engaging in aggressive tax-avoidance transactions.
I would point out that, where you engage in a transaction that misuses or abuses the provisions of the Act and is subject to the GAAR, then you can’t really say that you have complied with the provisions of the Act, because GAAR is a provision of the Act.
The disclosure exemption is considered quite important.
Coming Into Force Date
Q: Does Finance have any information about the coming-into-force date of the GAAR amendments?
A: The lack of coming-into-force dates in the Budget was a continuation on the theme of this being a discussion rather than announcing “this is how things are going to be, and it will be this way as of this date.” We were trying to avoid a Sword of Damocles situation, where people are worried that the changes would be retroactive. Our intended tone was more “we’re continuing to develop this, and we’ll announce a coming-into-force date in the future.”
This is a different approach than we take for announcing specific anti-avoidance rules, which have a clearer need for a coming-into-force date that prevents a race where taxpayers engage in as much avoidance as possible before that date. The GAAR doesn’t produce the same kind of problem.
Certainly, any penalty provisions would come into force prospectively only.
The purpose of the Budget announcement was just to state that there is an ongoing discussion. Dates will be announced in due course.