The General Anti-Avoidance Rule — updates and unanswered questions

The General Anti-Avoidance Rule (GAAR) was introduced to capture aggressive tax planning transactions and filing positions that involve a misuse or abuse of one or more provisions of the Income Tax Act. The courts have held that the GAAR was enacted as a provision of last resort to catch abusive tax avoidance and was not intended to introduce uncertainty in tax planning. Still, many advisors and tax professionals recommend transactions to clients without fully realizing or comprehending the effect these rules can have on taxpayers if caught under its regime.

These changes to the GAAR rules are effective retroactively to transactions occurring on or after Jan. 1, 2024. The new preamble and 25% GAAR penalty are exceptions — they’re both effective as of the date of C-59’s royal assent on June 20, 2024.

Historically, this has been determined by using a three-part test that must be satisfied in full for the Minister of National Revenue to apply the GAAR:

• The benefit test: a tax benefit resulting from a transaction or part of a series of transactions;
• The avoidance transaction test: that the transaction cannot be said to have been reasonably undertaken or arranged primarily for a bona fide purpose other than to obtain a tax benefit; and
• The abusive transaction test: that it cannot be reasonably concluded that a tax benefit would be consistent with the object, spirit or purpose of the provisions relied upon by the taxpayer.

The onus is on the taxpayer to refute the benefit test and avoidance test, and on the Minister of National Revenue to establish the abusive transaction test is met.

A new threshold

What has now changed is that there is now a significant reduction of the threshold for the avoidance transaction test from a “primary purpose” test to a “one of the main purposes” test.

Put another way, if one of the main purposes of a transaction is to obtain the relevant tax benefit, the threshold would now be met, even if there are other legitimate purposes to undertake the transaction.  

Additionally, the amendments added a key clarification that economic substance is a relevant consideration at the “abusive transaction” stage of a GAAR analysis.

Note that this does not, on its face, deem a lack of economic substance to be abusive on its own. Instead, the rule now states that if an avoidance transaction is “significantly lacking in economic substance,” it is an important consideration that “tends to indicate” abusive tax avoidance.

The new economic substance provision lists three non-exhaustive factors that may establish that a transaction or series of transactions is significantly lacking in economic substance:

• all or substantially all of the opportunity for gain or profit and risk of loss of the taxpayer — taken together with those of all non-arm’s length taxpayers — remains unchanged, including because of a circular flow of funds, offsetting financial positions or the timing between steps in the series;
• it is reasonable to conclude that, at the time the transaction was entered into, the expected value of the tax benefit exceeded the expected non-tax economic return (which excludes both the tax benefit and any tax advantages connected to another jurisdiction); and
• it is reasonable to conclude that the entire, or almost entire, purpose for undertaking or arranging the transaction or series was to obtain the tax benefit (see the Income Tax Act, ss. 245 (4.2)).

The concept of a “series of transactions” remains broad. Despite the change in wording, it appears likely that the Supreme Court of Canada’s holding in Canada Trustco Mortgage Co. v. Canada at paragraph 34 will remain instructive in this regard:

“If at least one transaction in a series of transactions is an “avoidance transaction,” then the tax benefit that results from the series may be denied under the GAAR. … Conversely, if each transaction in a series was carried out primarily for bona fide non-tax purposes, the GAAR cannot be applied to deny a tax benefit.”

Put another way, the existence of an arm’s length or bona fide commercial transaction within a broader series of transactions may not be indicative of economic substance within the entire series of transactions. Similarly, the inclusion of a seemingly ancillary transaction with commercial elements in a series of transactions could potentially be excluded from the analysis if it is found to be unrelated to the remainder of the transactions that give rise to the tax benefit being subject to the GAAR.

Which transactions apply?

This creates a question in each instance on which transactions form the base of the series of transactions, and which do not.

In order to be able to take any reasonable position on the applicability of the GAAR, it is generally required for of National Revenue to define which provisions of the Income Tax Act are being alleged to be misused or abused.

However, in a GAAR analysis, the object, spirit, and purpose of the provisions are assessed. That can go beyond the usual statutory analysis, as noted by the Supreme Court in Deans Knight Income Corp. v. Canada.

While the court held this under the old rules, it is highly likely this case and its commentary on GAAR analysis remains instructive when assessing the new rules.

Historically, GAAR decisions have often turned on whether a misuse or abuse has occurred. This will likely still be the case with the application of the new rules. However, a significant question remains on what weight prior case law will have, considering that it is primarily based in the old rules.

There remains a relative dearth of case law on the new rules, as there is a significant (and justifiable) hesitation on behalf of taxpayers and their professionals to be the test case should a highly costly and unfavourable result distort interpretation of GAAR.

What appears to be a likely risk for taxpayers and tax professionals to be mindful of, is the potential for the Canada Revenue Agency to seek to apply GAAR automatically should they believe that a transaction is “significantly lacking in economic substance,” and assume the remainder of the abusive transaction test has been met. This is not how either the old rule or the new rule is intended to apply, as both are intended to require rigorous analysis to conclude that all three tests are met.

The value of a GAAR analysis

A GAAR analysis is often a key consideration in tax planning, and ultimately a GAAR analysis is a legal conclusion, not a statement of fact. It’s also generally costly on its own. Failure to take the time to assess and address the GAAR can become significantly costlier though, be it via legal opinion, tax insurance (a specialized offering that covers potential financial losses arising from a successful challenge of a taxpayer’s filing position by CRA or other tax authority), removal of problematic steps, or even refraining from engaging in a plan that may no longer be innocuous altogether.

While there may be some value in a GAAR opinion in certain cases, an opinion generally needs to be sufficiently qualified and well considered by specialist practitioners in order to result in a viable and realistic legal conclusion.

Where provisions intended to address GAAR risk are inserted directly into commercial documents, this may also serve to attract greater attention and re-assessment risk, so this needs to be assessed by experienced tax professionals on a case-by-case basis. Broader tax indemnities, tax insurance or other representations and warranties may be more appropriate depending on, amongst other things, the nature and scale of the transactions and sophistication of the parties.

With specific regard to professionals who purport to provide tax advice, it is also increasingly important to consider that failure to adequately advise a client could result in litigation, including potential cost awards against the planner as well if it is determined that they insufficiently warned the taxpayer of the risks of GAAR in tax planning.

Certain courts have attempted to impose a duty on professionals to assess the likelihood and potential implications of the GAAR’s application to tax planning, including a potential duty to discuss the GAAR when advising their clients, and even new developments in taxation relevant to their clients’ situations. (See for example, 4258843 Canada inc. v. KPMG.)

The GAAR is a highly technical and nuanced anti-avoidance regime with many unanswered questions in its application that has only intensified since the rollout of the new rules. For that reason, it is incumbent on professionals to be aware of its potential effects, and to seek out specialist advice where necessary and appropriate.