Canadian General Anti-Avoidance Rule (GAAR)

Doing what is legally best for your business and its advancement into Canada, given Canada's strict tax-related rules.

Contact Neufeld Legal PC at 403-400-4092 / 905-616-8864 or Chris@NeufeldLegal.com

The Canadian government's General Anti-Avoidance Rule (GAAR) is a complex and powerful tool used by the Canada Revenue Agency (CRA) to combat what it considers "abusive" tax avoidance. While the GAAR applies to all taxpayers, its application to Canadian subsidiary corporations of foreign parent corporations is particularly important due to the international tax planning strategies that can be employed in such structures.

The General Anti-Avoidance Rule's Framework

The legislative specifics of GAAR are found in section 245 of the Income Tax Act (Canada). It operates as a rule of last resort, meaning it is applied to deny a tax benefit that is otherwise technically compliant with the law. The GAAR test has three key parts, and all three must be met for the CRA to successfully apply it:

• Tax Benefit: There must be a tax benefit resulting from a transaction. A tax benefit is defined broadly to include a reduction, avoidance, or deferral of tax, or an increase in a refund.

• Avoidance Transaction: The transaction must be an "avoidance transaction." A transaction is an avoidance transaction if it results, directly or indirectly, in a tax benefit, and it can reasonably be considered that one of the main purposes of the transaction was to obtain that tax benefit. This is a significant change from the previous rule, which required the primary purpose to be tax-related.

• Misuse or Abuse: The avoidance transaction must result in a misuse of the provisions of the Income Tax Act, or an abuse of the provisions of the Act read as a whole. This is the most subjective and contested part of the GAAR analysis. It requires a "textual, contextual, and purposive analysis" of the provisions to determine if the transaction frustrates their object, spirit, and purpose.

Application to Canadian Subsidiaries of Foreign Parent Corporations

For Canadian subsidiaries of foreign parent corporations, the GAAR can be a significant concern in a variety of cross-border tax planning scenarios. The CRA and the Department of Finance have focused on certain types of transactions that they view as particularly susceptible to GAAR, including those that involve international tax treaties.

Some specific areas where the GAAR may be invoked in a foreign-parent/Canadian-subsidiary context include:

• Surplus Stripping: This involves transactions for the benefit of a non-resident shareholder that result in the withdrawal of a Canadian corporation's surplus in a way that reduces the Canadian tax base. The CRA views this as a potential abuse of the provisions related to corporate distributions and dividends.

• Treaty Shopping: This is a strategy where a non-resident of Canada, who is a resident of a non-treaty country, uses an intermediary entity in a treaty country to access tax benefits (e.g., a reduced withholding tax rate) under a Canada tax treaty. While the Supreme Court of Canada has ruled in favor of the taxpayer in a prominent treaty shopping case (Alta Energy), the 2024 amendments to the GAAR and the introduction of a new preamble are intended to address interpretive issues and strengthen the CRA's position on these types of arrangements.

• Creation of Artificial Capital Losses: The GAAR can be used to challenge arrangements where a foreign parent or its subsidiary undertakes transactions to create a capital loss that does not reflect a true economic decline in value. These transactions are seen as misusing or abusing the provisions related to capital gains and losses.

• Interest Deductibility: The GAAR could be used to challenge interest expenses incurred by a Canadian subsidiary on debt issued by a foreign parent, particularly if the arrangement is considered to lack economic substance and is primarily intended to reduce Canadian taxable income.

Recent Changes to the General Anti-Avoidance Rule

The Canadian government has recently introduced significant changes to the GAAR, which will have a profound impact on international tax planning for Canadian subsidiaries. These changes, enacted in 2024 through Bill C-59, include:

• Lowered Threshold for Avoidance Transaction: As mentioned above, the purpose test for an avoidance transaction has been lowered from "primarily" to "one of the main purposes." This makes it easier for the CRA to meet the first part of the GAAR test.

• Economic Substance Rule: The new legislation adds an explicit "economic substance" test. If a transaction is found to be "significantly lacking in economic substance," it is an "important consideration that tends to indicate" a misuse or abuse of the law. This codifies a principle that has been part of judicial decisions but gives it a more formal standing.

• New Preamble: A preamble has been added to the GAAR to help guide interpretation and clarify that the rule is intended to deny tax benefits from avoidance transactions that result in a misuse or abuse of the tax law while still allowing for legitimate tax planning.

• Penalties: A new penalty of 25% of the denied tax benefit can now be imposed when the GAAR is successfully applied.

• Extended Reassessment Period: The reassessment period for a GAAR application has been extended by three years, unless the transaction was disclosed to the CRA.

The General Anti-Avoidance Rule is a powerful tool that is wielded by the CRA, and its recent amendments have strengthened its ability to challenge aggressive tax planning. For Canadian subsidiary corporations of foreign parent corporations, it is more important than ever to ensure that tax planning strategies are not only technically compliant but also align with the underlying object, spirit, and purpose of the Income Tax Act and relevant tax treaties.

To learn more about how our law firm stands apart when it comes to expanding your business into Canada, in what we do differently from most larger law firms and how this can properly protect and advance your Canadian commercial venture, contact our law firm today for a confidential initial consultation at Chris@NeufeldLegal.com or 403-400-4092 / 905-616-8864.  

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