When Canada Trustco Mortgage Co. agreed to finance Transamerica Leasing Inc.'s $100 million purchase of a tractor-trailer fleet in 1996, its tax advisers came up with a novel leaseback scheme that they thought would reduce the company's financial risk while allowing it to claim depreciation of $82 million to reduce its tax obligations in subsequent years.

While Canada Trustco viewed the plan as a legitimate cost-saving strategy, the Canada Revenue Agency (CRA) wasn't impressed. It disallowed the deductions by invoking the general anti-avoidance rule (GAAR) found in Canada's Income Tax Act (ITA). Introduced in 1987, the rule gives CRA broad discretion to void tax minimization schemes it views as abusive, but just how broad that discretion is has never been clear. The uncertainty, along with the paucity of jurisprudence on the subject, has troubled companies doing business in Canada for decades.

“For the past 20 years companies have been operating in something of a tax vacuum,” says Professor Vern Krishna of the University of Ottawa's Faculty of Law.

The Supreme Court of Canada, however, handed down its first two GAAR interpretations on Oct. 19, including one involving the Canada Trustco scheme.

The results were mixed–the taxpayer won in Canada Trustco v. Canada and lost in Mathew v. Canada–and the Supreme Court acknowledged that the line between legitimate tax minimization and abusive tax avoidance “is far from bright.”

But the two cases have this in common: Both place the burden of establishing abuse squarely on the government.

Defining Costs

Canada Trustco arose from a 1996 sale-leaseback in which Canada Trustco, one of the country's largest financial institutions, purchased a $100 million tractor-trailer fleet from Transamerica. Canada Trustco obtained the money by way of a loan from the Royal Bank and then leased the trailers back to the company.

Sale-leaseback structures are a common way for capital-intensive industries to minimize capital outlay. Normally, a lessee pays out the lease in installments. In this case, Transamerica prepaid a significant amount of its obligations and used the money to pay down the Royal Bank loan. That meant Canada Trustco got its purchase money back quickly.

Canada Trustco claimed depreciation of about $26 million in 1997 and $56 million in 1998. CRA disallowed the deduction in 2002. The agency reasoned that because Transamerica had prepaid a significant amount of the money owed, Canada Trustco had incurred no real cost against which to apply depreciation.

“The smoking gun from CRA's point of view was that the money went back to Canada Trustco in a circle,” says Al Meghji, the partner at Osler Hoskin & Harcourt who represented Canada Trustco.

The company appealed and the case wound its way to the Supreme Court, which found CRA acted outside the scope of its discretion in disallowing the deductions. Canada Trustco's minimization of its tax liability, the court reasoned, was within the object, spirit and purpose of the capital cost allowance provisions of the ITA, largely because the Transamerica transaction didn't differ materially from the industry norm.

That was good news for companies pursuing creative ways to reduce tax liability. The taxpayers in Mathew, however, didn't fare nearly as well.

A Frustrated Policy

When Standard Trust Co. became insolvent in 1991, the liquidator sought to maximize returns on the disposal of certain mortgages. This required a transaction that would allow the assets' purchasers to reap tax benefits from Standard Trust's losses.

The difficulty the liquidator faced was that the ITA doesn't allow purchasers to claim the purchased company's losses. To get around that, Standard sold its unrealized losses to a partnership composed of itself and an unrelated third party. But because Standard retained an interest in this partnership, the partnership could claim the mortgage losses if it so chose.

But the partnership didn't claim the losses before the purchaser bought Standard's interest. This created a new partnership between the purchaser and Standard's former partner. Because the former partner kept its interest, the new partnership remained related to the previous partnership. The 18 purchasers who were the appellants in Mathew argued that this series of transactions allowed them to claim their proportionate share of Standard's original losses–about $8.5 million.

The Supreme Court disallowed the deduction, reasoning that the purpose of the partnership provisions and the tax-loss provisions is to prohibit the transfer of losses between arm's-length taxpayers. The transactions in Mathew couldn't stand because they frustrated the policy underlying the provisions that the taxpayers relied on to make their case. As a result, the CRA was justified in applying GAAR.

Although this outcome was not favorable to the business seeking to reduce its tax burden, the Court still made it clear that CRA bore the burden of establishing that the transaction was “abusive.”

Future Battles

Although the Supreme Court provided no definitive answer to what offends GAAR, it did provide a consistent guide to interpreting the Income Tax Act.

“The overriding point is the Court's affirmation that the interpretation of tax statutes is no different from the interpretation of all statutes,” Krishna explains. “Gone are the days when tax statutes were considered penal statutes to which a literal interpretation is applied.”

In other words, companies wishing to minimize their tax liability can't do so by simply stringing together literal readings of individual provisions in the ITA (as the taxpayers did in Mathew). Rather, they have to determine the purpose of individual provisions to ensure that their transactions didn't thwart the legislation's intent.

“What the Supreme Court told taxpayers and the CRA is that the interpretation of the ITA must be an exercise in thoughtful judgment,” Meghji says.

That, however, might be a double-edged sword.

“You're probably OK if your structure doesn't frustrate the provisions of the income tax act and otherwise complies with the Act,” says Thomas Akin, a tax partner at McCarthy T?? 1/2 trault's Toronto office. “On the other hand, a tax structure that is technically sound because it complies with a literal reading of the Act will not work if it ends up frustrating the policy that's behind the rules.”

So some tax lawyers say they will approach the future with caution.

“It's going to take a while for the CRA and the taxpayers to determine how these judgments shake out,” says Ronald Durand, a partner at Stikeman Elliott. “The next shootout should occur in about four or five years.”?

When Canada Trustco Mortgage Co. agreed to finance Transamerica Leasing Inc.'s $100 million purchase of a tractor-trailer fleet in 1996, its tax advisers came up with a novel leaseback scheme that they thought would reduce the company's financial risk while allowing it to claim depreciation of $82 million to reduce its tax obligations in subsequent years.

While Canada Trustco viewed the plan as a legitimate cost-saving strategy, the Canada Revenue Agency (CRA) wasn't impressed. It disallowed the deductions by invoking the general anti-avoidance rule (GAAR) found in Canada's Income Tax Act (ITA). Introduced in 1987, the rule gives CRA broad discretion to void tax minimization schemes it views as abusive, but just how broad that discretion is has never been clear. The uncertainty, along with the paucity of jurisprudence on the subject, has troubled companies doing business in Canada for decades.

“For the past 20 years companies have been operating in something of a tax vacuum,” says Professor Vern Krishna of the University of Ottawa's Faculty of Law.

The Supreme Court of Canada, however, handed down its first two GAAR interpretations on Oct. 19, including one involving the Canada Trustco scheme.

The results were mixed–the taxpayer won in Canada Trustco v. Canada and lost in Mathew v. Canada–and the Supreme Court acknowledged that the line between legitimate tax minimization and abusive tax avoidance “is far from bright.”

But the two cases have this in common: Both place the burden of establishing abuse squarely on the government.

Defining Costs

Canada Trustco arose from a 1996 sale-leaseback in which Canada Trustco, one of the country's largest financial institutions, purchased a $100 million tractor-trailer fleet from Transamerica. Canada Trustco obtained the money by way of a loan from the Royal Bank and then leased the trailers back to the company.

Sale-leaseback structures are a common way for capital-intensive industries to minimize capital outlay. Normally, a lessee pays out the lease in installments. In this case, Transamerica prepaid a significant amount of its obligations and used the money to pay down the Royal Bank loan. That meant Canada Trustco got its purchase money back quickly.

Canada Trustco claimed depreciation of about $26 million in 1997 and $56 million in 1998. CRA disallowed the deduction in 2002. The agency reasoned that because Transamerica had prepaid a significant amount of the money owed, Canada Trustco had incurred no real cost against which to apply depreciation.

“The smoking gun from CRA's point of view was that the money went back to Canada Trustco in a circle,” says Al Meghji, the partner at Osler Hoskin & Harcourt who represented Canada Trustco.

The company appealed and the case wound its way to the Supreme Court, which found CRA acted outside the scope of its discretion in disallowing the deductions. Canada Trustco's minimization of its tax liability, the court reasoned, was within the object, spirit and purpose of the capital cost allowance provisions of the ITA, largely because the Transamerica transaction didn't differ materially from the industry norm.

That was good news for companies pursuing creative ways to reduce tax liability. The taxpayers in Mathew, however, didn't fare nearly as well.

A Frustrated Policy

When Standard Trust Co. became insolvent in 1991, the liquidator sought to maximize returns on the disposal of certain mortgages. This required a transaction that would allow the assets' purchasers to reap tax benefits from Standard Trust's losses.

The difficulty the liquidator faced was that the ITA doesn't allow purchasers to claim the purchased company's losses. To get around that, Standard sold its unrealized losses to a partnership composed of itself and an unrelated third party. But because Standard retained an interest in this partnership, the partnership could claim the mortgage losses if it so chose.

But the partnership didn't claim the losses before the purchaser bought Standard's interest. This created a new partnership between the purchaser and Standard's former partner. Because the former partner kept its interest, the new partnership remained related to the previous partnership. The 18 purchasers who were the appellants in Mathew argued that this series of transactions allowed them to claim their proportionate share of Standard's original losses–about $8.5 million.

The Supreme Court disallowed the deduction, reasoning that the purpose of the partnership provisions and the tax-loss provisions is to prohibit the transfer of losses between arm's-length taxpayers. The transactions in Mathew couldn't stand because they frustrated the policy underlying the provisions that the taxpayers relied on to make their case. As a result, the CRA was justified in applying GAAR.

Although this outcome was not favorable to the business seeking to reduce its tax burden, the Court still made it clear that CRA bore the burden of establishing that the transaction was “abusive.”

Future Battles

Although the Supreme Court provided no definitive answer to what offends GAAR, it did provide a consistent guide to interpreting the Income Tax Act.

“The overriding point is the Court's affirmation that the interpretation of tax statutes is no different from the interpretation of all statutes,” Krishna explains. “Gone are the days when tax statutes were considered penal statutes to which a literal interpretation is applied.”

In other words, companies wishing to minimize their tax liability can't do so by simply stringing together literal readings of individual provisions in the ITA (as the taxpayers did in Mathew). Rather, they have to determine the purpose of individual provisions to ensure that their transactions didn't thwart the legislation's intent.

“What the Supreme Court told taxpayers and the CRA is that the interpretation of the ITA must be an exercise in thoughtful judgment,” Meghji says.

That, however, might be a double-edged sword.

“You're probably OK if your structure doesn't frustrate the provisions of the income tax act and otherwise complies with the Act,” says Thomas Akin, a tax partner at McCarthy T?? 1/2 trault's Toronto office. “On the other hand, a tax structure that is technically sound because it complies with a literal reading of the Act will not work if it ends up frustrating the policy that's behind the rules.”

So some tax lawyers say they will approach the future with caution.

“It's going to take a while for the CRA and the taxpayers to determine how these judgments shake out,” says Ronald Durand, a partner at Stikeman Elliott. “The next shootout should occur in about four or five years.”?