Updated tax-avoidance proposals include new penalty

The federal government has refined its proposed amendments to the general anti-avoidance rule (GAAR), but tax lawyers remain concerned about the rule’s overreach.

In 2022, the Department of Finance released a consultation paper suggesting methods to revamp the GAAR, which kicks in to deny tax benefits arising from transactions that misuse or abuse Income Tax Act provisions.

While GAAR has “proven to be a reasonably effective tool for preventing abusive tax avoidance,” the government argued that tax authorities needed a stronger rule to keep up with certain taxpayers’ use of increasingly complex tax avoidance structures.

The 2022 consultation rang alarm bells for Pooja Mihailovich, a partner with Osler Hoskin & Harcourt LLP in Toronto — particularly because of proposals that would expand the definition of a “transaction” to include certain taxpayer choices about how a transaction is carried out, and that would make taxpayers prove their claimed tax benefits are in line with the law, rather than force the Crown to establish abuse.

Neither suggestion ultimately made the cut when the federal government delivered concrete proposals to amend the GAAR as part of the 2023 federal budget, but the latest draft legislation — issued Aug. 4 following a fresh consultation round — still leaves much to be desired, Mihailovich said.

“The revised draft amendments released in August do not adopt some of the more egregious measures that were initially under consideration, but they still risk creating uncertainty for taxpayers and undermining the continued efforts of the courts to ensure that the application of the GAAR remains rigorous,” she said.

The most recent proposals lower the threshold for an avoidance transaction from one whose primary purpose is obtaining a tax benefit to a transaction where a tax benefit is “one of the main purposes.”

In addition, the amendments would create a rebuttable presumption of abuse or misuse for transactions that are “significantly lacking in economic substance.”

But Mihailovich said courts have been accounting for the economic substance of transactions throughout the 35 years since the GAAR’s introduction.

“Considering whether transactions have economic substance as a freestanding requirement and in isolation from the specific provisions at issue risks compounding the uncertainties already associated with the GAAR,” she said.

The Aug. 4 draft legislation could be seen as more of a codification of existing GAAR case law, said Steve Suarez, partner with Borden Ladner Gervais LLP.

“If not, then it’s essential the government comes out and tells us, so that we can be on notice,” Suarez said, adding that he’s worried the new legislation could change the results of previous court decisions that were in favour of taxpayers. “We all have a shared interest in a robust and effective GAAR. The objective should be to have that in a way that does not overreach, such that people who want to do the right thing are penalized and people who want to stay on the right side of the line have no good sense of where that line is.”

Suarez said the most eye-catching change to the GAAR regime for taxpayers is likely to be a new penalty, which extends the statutory limitation period for assessment or reassessment when the rule applies to six years from three years (or seven years from four years for some corporate situations).

“What’s really troubling people is [the] penalty is not dependent on the reasonableness of the taxpayer’s conduct, how close a call it was or some other standard. It simply applies automatically,” Suarez said.

In the 2023 budget, the penalty was initially conceived as a 25% levy on the total tax benefit obtained from any transactions found subject to the GAAR. However, under the draft legislation, the government intends to assess the penalty as 25% of the additional tax owing by a taxpayer as a result of the GAAR’s application — reduced by the amount of any “gross negligence” penalty already imposed to avoid duplication.

The new penalty “is probably going to produce more GAAR disputes, because there is more money at stake,” Suarez said. “If there’s a 25% penalty right out of the gate, then people are going to be more inclined to litigation because the cost of losing is that much bigger.”

Also following the last round of consultations, a new exception was added so the penalty will not apply to transactions that are “identical or almost identical” to those that were the subject of government guidance or court decisions indicating the GAAR would not apply.

In addition, taxpayers will be able to avoid penalties and reassessments related to specific transactions that are disclosed — whether voluntarily or as required legislatively — under the Canada Revenue Agency’s new mandatory disclosure regime that took effect in June.

If the penalty proposals do become law, Mihailovich said they will represent a “significant shift” in the operation of the GAAR.

“It was previously well-understood that the GAAR is not a penal provision, and that taxpayers cannot self-assess under the GAAR,” she said.

By contrast, as the proposals stand, “taxpayers may effectively be coerced into reporting legitimate transactions that they have prudently determined not to be abusive, for fear of being subject to the penalty or extended limitation period,” Mihailovich added.

The revised proposals also saw the deletion of a portion of the GAAR preamble emphasizing that the rule will apply regardless of whether a “tax strategy is foreseen.”

Suarez said the clause was no longer needed after the Supreme Court of Canada’s recent decision in Deans Knight Income Corp. v. Canada, which contradicted a series of cases that indicated that the GAAR would not apply if Parliament declined to expand specific anti-avoidance measures against a known tax strategy.

The May 26 decision upheld the application of the GAAR against a drug research company after a 7-1 majority concluded that the use of tax attributes to shelter income from a new business was an abuse of Income Tax Act provisions restricting non-capital loss carryovers, even though the corporation had not undergone a change in de jure control.

“Deans Knight has made it crystal clear that GAAR absolutely can apply to tax planning that is foreseeable,” said Suarez, who appeared before the Supreme Court in the case, acting for the Canadian Chamber of Commerce as an intervenor. “To my mind, the decision was not a radical departure from the existing GAAR jurisprudence, and in many ways reiterated a number of the existing principles previously articulated by the court, including those regarding economic substance.”

The consultation period for the GAAR proposals ended on Sept. 8.