01 July 2010 Issue 7 Sean Dooley

GAAR: Certainty in doubt?

The impact of the recent case of Lehigh on the uncertainty surrounding the GAAR.

Until the introduction of the general anti-avoidance rule (GAAR) in 1988, one of the greater certainties in Canadian tax, while not absolute, was the Duke of Westminster principle that taxpayers may order their affairs so as to minimise the amount of tax payable. The GAAR introduced significant uncertainty and great apprehension as to whether taxpayers could seek to minimise tax. Initially, the GAAR was feared as a ‘big stick’ to reign-in taxpayers and tax planners alike. As the GAAR cases worked their way through the courts, the apprehension may have diminished, but uncertainty remained.

The decision from the Supreme Court of Canada (Supreme Court) in Canada Trustco Mortgage Co v The Queen 2005 SCC 54 provided a welcome framework in applying the GAAR and restored a measure of certainty. Particular comfort was gleaned from the following words of the Supreme Court:

‘The GAAR was enacted as a provision of last resort in order to address abusive tax avoidance, it was not intended to introduce uncertainty in tax planning.’

With the Supreme Court’s split decision in Earl Lipson v The Queen 2009 SCC 1, many commentators and the dissenting judges expressed concern that Lipson introduced new and improved uncertainty. Consider the view of one dissenting judge:

‘The approbation by the Court of the Minister’s resort to vague generalities or “overriding policy” would only increase the element of uncertainty in tax planning that Canada Trustco sought to avoid.’

There are fears that the ‘big stick’ is back and even whispers of a smell test.


On 17 May 2010, the ‘certainty’ of the GAAR took another twist when the Federal Court of Appeal (Federal Court) allowed the taxpayer’s appeal in Lehigh Cement Limited v The Queen, 2010 FCA 124, reversing the decision of the Tax Court of Canada (Tax Court). The Tax Court had applied the GAAR to a series of transactions that resulted in the avoidance of withholding tax under the so-called ‘5/25 Exemption’ in subparagraph 212(1)(b)(vii) of Canada’s Income Tax Act(the Act), as it then applied. In general terms, the 5/25 Exemption required that interest be paid to an arm’s length party and that under no circumstances was the debtor required to pay more than 25 per cent of the principal amount owing within five years of the date of issue of the debt. Although Canada has since eliminated withholding tax on all arm’s length interest (other than participating interest), Lehigh raises the hopes of renewed certainty in the unfolding drama of the GAAR through the courts.

The appeal stemmed from the Minister’s reassessment of the taxpayer’s 1998 to 2002 taxation years denying approximately CAD39.8 million in interest deductions and, in the alternative, applying the GAAR to assess almost CAD7 million in unremitted withholding tax on interest paid to an arm’s length non-resident bank. The Tax Court found in favour of the taxpayer with regards to interest deductibility, but found in favour of the Crown as to the application of the GAAR. Only the taxpayer appealed to the Federal Court. The Federal Court found in the taxpayer’s favour.


Lehigh was a Canadian corporation that carries on business in Canada as a manufacturer of cement and construction materials, and was a member of a related group of corporations (the HZ Group) ultimately controlled by a German publicly traded company, Heidelberger Zement. In 1986, Lehigh borrowed CAD140 million from a consortium of Canadian banks to acquire business assets. The loan was later sold by the banks to a corporation in the HZ Group and in 1994 came to be held by a related Belgian corporation named CBR International Services (CBR). CBR acted as the treasury centre to the HZ Group. The loan to Lehigh bore floating rate interest based on Canadian prime and was to be repaid in full on 15 September 2009, subject to Lehigh’s option to extend the term for successive periods of five years. While the loan was outstanding to CBR, Lehigh withheld and remitted 15 per cent tax on interest paid to a non-resident as required under the Act.

The series of transactions

In August 1997, Lehigh implemented a plan with the intended result of eliminating non-resident withholding tax and the expectation of realising a net present value tax savings in the range of CAD13.1 to CAD19.7 million, depending on interest rates. To meet the tests of the 5/25 exemption, the plan required amending the terms of the existing loan and introducing an arm’s length party.

The terms of the loan amendments were summarised by the Federal Court as follows:

‘The interest rate was changed from the Canadian prime rate to a fixed rate of 7 per cent for the first five years.

‘Except in the event of a default, Lehigh was not obliged to repay more than 25 per cent of the principal amount within five years of the date upon which the new terms were agreed to.

The holder of the Lehigh debt […] was given the right to sell to a third party all or any portion of the right to be paid interest on the loan.

A withholding tax gross-up clause was added. That is, Lehigh agreed that if any withholding tax was payable on the interest, Lehigh would effectively bear the increased cost.’

In the same month, an arm’s length Belgian bank purchased from CBR the right to be paid all quarterly interest payable by Lehigh for five years. The consideration paid to CBR was approximately CAD42.7 million for the right to receive a total of approximately CAD49.5 million in interest. To secure its position in the event of default by Lehigh, the Belgian bank had the right, under a separate put agreement, to require CBR to pay any deficient interest. Further, the Belgian bank obtained an indemnity from CBR to cover any hedging losses that could arise in the event of an early payout of interest.

Thereafter, Lehigh paid all quarterly interest to the Belgian bank. On the basis that the arm’s length test and the five-year test were met, Lehigh did not withhold tax on the payments to Belgian bank. Meanwhile, Lehigh remained indebted to CBR for the entire principal amount of CAD140 million.

Misuse or doubt?

The Crown agreed that the interest on the loan met the conditions to qualify for the 5/25 Exemption, but took the position that the GAAR applied to deny the exemption. In following the three-step Canada Trustco approach to the application of the GAAR, Lehigh conceded that the series of transactions were avoidance transactions that resulted in a tax benefit.

The Federal Court maintained that the burden remained with the Crown to establish ‘that allowing Lehigh the benefit of the exemption […] would be a misuse of that provision, in the sense that it would achieve an outcome that [it] is intended to prevent or is not intended to permit.’ However the Federal Court emphasised that ‘most importantly, if there is any doubt as to whether the transaction in issue results in a misuse […], Lehigh is entitled to the benefit of that doubt.’

The Crown’s central argument in applying the GAAR was that a non-resident person is not entitled to benefit from the 5/25 Exemption where the right to receive interest is split from the right to receive the principal amount because the transactions did not result in Lehigh ‘accessing funds in an international capital market’. The phrase quoted by the Crown was an excerpt from a 1975 Department of Finance budget paper that first proposed the 5/25 Exemption. The Crown did not produce any other evidence to explain the underlying rationale for the exemption and provided no authority to support that the splitting the interest and principal obligation was considered ‘in 1975 or at any later time to have offended the fiscal policy objective’ of the 5/25 Exemption. In fact, the Federal Court found evidence to the contrary.

The Federal Court rejected the Crown’s invitation to conclude that entitlement to the exemption is ‘subject to a condition necessarily implied by the existence of a fiscal policy, evidenced only by a sentence in a 1975 budget paper that is said to explain why the exemption was enacted’.

The Federal Court found no trace of the Crown’s alleged fiscal policy in the 5/25 Exemption provision itself, from the statutory scheme of which the provision is a part, or from any other provision of the Act ‘that could possibly be relevant to the textual, contextual and purposive interpretation’ of the provision. The Federal Court stated that it was ‘fatal to the Crown’s misuse argument that it finds no support in any provision of the Income Tax Act, or in any jurisprudence or other authority saying or suggesting that the splitting of the interest and principal obligations of a debt have any income tax implications in relation to subparagraph 212(1)(b)(vii), or any analogous provision or relevant statutory scheme’.

Echoing the Duke of Westminster and Canada Trustco, the Federal Court reminded the Crown that when Parliament adds an exemption to the Act, ‘it cannot possibly describe every transaction within or without the intended scope of the exemption. Therefore, it is conceivable that a transaction may misuse a statutory exemption comprised of one or more bright line tests such as, in this case, the arm’s length test and the five-year test. However, the fact that an exemption may be claimed in an unforeseen or novel manner, as may have occurred in this case, does not necessarily mean that the claim is a misuse of the exemption. It follows that the Crown cannot discharge the burden of establishing that a transaction results in the misuse of an exemption merely by asserting that the transaction was not foreseen or that it exploits a previously unnoticed legislative gap. As I read Canada Trustco, the Crown must establish by evidence and reasoned argument that the result of the impugned transaction is inconsistent with the purpose of the exemption, determined on the basis of a textual, contextual and purposive interpretation of the exemption.’

Lehigh was heard by the Tax Court before the Supreme Court issued its Lipson decision, but the lower court’s decision was rendered after the Lipson decision was released. In obiter, the Tax Court judge explained that he did not rely on Lipson or invite counsel for further submissions because the Supreme Court was divided, the facts in Lipson differed from those in Lehigh and ‘the various reasons for judgment in Lipson do not qualify what the Supreme Court stated in its unanimous decision in Canada Trustco’. The Federal Court’s decision was silent on Lipson, but stated that ‘counsel for both parties cited and relied on the unanimous decision of the Supreme Court’ in Canada Trustco in applying the GAAR. One wonders if the Federal Court went out of its way to subtly agree with the Tax Court by choosing the words ‘unanimous decision’.

Although the reversal of Lehigh itself by the Federal Court may be viewed as contributing to the uncertainty surrounding the GAAR, the message may be broader than that. Arguably, Lehigh restores a measure of certainty to the principle that when there is any doubt as to whether there is a misuse or abuse of the provisions of the Act when a taxpayer is arranging his or her affairs to minimise tax, the taxpayer should be entitled to the benefit of the doubt. It also inspires confidence that, as questioned by the Supreme Court in Canada Trustco, the Federal Court is unwilling to formulate taxation policies that are not grounded in the provisions of the Act and certainly will not apply ungrounded policies to override the specific provisions of the Act. So it would seem that certainty can be found in doubt.