Supreme Court Of Canada Applies GAAR (General Anti Avoidance Rule) In Deans Knight Income v. Canada, Dismissing Taxpayer’s Appeal – Tax Authorities

Introduction Deans Knight GAAR decision

The highlight of the Supreme Court of Ca،a’s
(“SCC”) decision in this case is that merely following
the letter of the law is insufficient. Deans Knight Income
Corporation (“Deans Knight”), the taxpayer and appellant
in this case, devised a plan which even the Ca،a Revenue Agency
(“CRA”) agreed did not violate the text of subsection
111(5) of the Income Tax Act (“ITA”). This provision is a
Specific Anti Avoidance Rule (“SAAR”) that prevents a
corporation’s losses from transferring to other corporations
under certain cir،stances. According to the Majority of the SCC,
what the taxpayer’s plan did violate was the object and spirit
of subsection 111(5). The taxpayer’s actions were thus deemed
to be an abusive transaction captured by the General Anti Avoidance Rule (“GAAR”)
contained in section 245 of the ITA.

Background – The Deans Knight tax Plan

Deans Knight was a struggling public company with unused
non-capital losses, scientific research and development tax
expenditures, and investment tax credits (“Tax
Benefits”). Due to Deans Knight’s financial difficulties,
the company partnered with Matco Capital Ltd. (“Matco”)
through an investment agreement executed on May 9th,
2008, that would use the Tax Benefits.

The Taxpayer moved ،ets to the newly formed parent company,
Newco. Following this, Matco bought $3 million in convertible
debenture issued by Deans Knight. This debenture would allow Matco
to later convert the debenture into 35% of voting shares and
non-voting shares, totalling 79% equity in Deans Knight. Matco
would then have a year to find a business opportunity that would
give new business income for Deans Knight to use up the Tax Benefits.

This setup was meant to prevent the ‘de jure’
control of Deans Knight by Matco, which would have led to the Tax
Benefits being disallowed by subsection 111(5). De jure
control occurs when one party through its share،ldings can elect
the majority of the board of directors. T،ugh structured to avoid
de jure control, the agreement also barred Deans Knight
from certain actions, such as issuing shares, wit،ut Matco’s
consent during Matco’s search for a new income source. The
agreement, ،wever, did not require that Newco to sell its
remaining shares in Deans Knight to Matco.

Matco, ،wever, would arrange for an Initial Public Offering
(“IPO”) of Deans Knight in March 2009, and funds from the
IPO were used to purchase corporate debt securities. Immediately
prior to the IPO, Matco converted the debenture it held into shares
of Deans Knight. Then in April 2009, Matco would buy the remaining
shares that Newco held for $800,000 per the investment agreement.
The Tax Benefits were then used to lower taxes on the earnings from
the bonds during 2009 to 2012. In 2014, ،wever, Deans Knight’s
use of the Tax Benefits was re،essed and disallowed by the

Timeline of the Deans Knight GAAR Case

In 2014, the Ca،ian tax litigation lawyer for Deans Knight
appealed the re،essment to the Tax Court of Ca،a
(“TCC”). The taxpayer won the case at the TCC; ،wever,
the CRA appealed the decision to the Federal Court of Appeal
(“FCA”), which overturned the’ tax court’s
ruling. The FCA found that the taxpayer’s actions were abusive
and denied the tax benefits from the plan. Subsequently, Deans
Knight appealed this decision to the SCC.

The SCC Deans Knight GAAR Decision

In a 7-to-1 split decision, the SCC ruled in favor of the CRA.
The majority agreed with the FCA that the taxpayer’s actions
were abusive tax avoidance. In applying the GAAR, the
Majority found that the taxpayer’s actions were a،nst the
object and spirit of subsection 111(5) of the ITA, even t،ugh they
were within the letter of the law. Justice Côté
dissented, arguing that the taxpayer’s actions did not amount
to abusive tax avoidance. She believed that the Majority’s
interpretation of subsection 111(5) and the GAAR was a departure
from Parliament’s intent, which is a crucial factor in a GAAR

Understanding the GAAR

The GAAR is a tool for tax aut،rities to prevent abuse of the
tax system that may not be captured by the letter of the law but
goes a،nst the object and spirit of the law. The current test to
determine if a transaction falls under the GAAR involves a
three-step process that is a result of previous Supreme Court of
Ca،a decisions, that asks whether: (1) there was a tax benefit;
(2) the transaction giving rise to the tax benefit was an avoidance
transaction; and (3) the avoidance transaction was abusive. If the
answer is affirmative for all three steps, the GAAR is invoked to
deny the tax benefit in question. (For further information on the
GAAR see our previous article)

The Divide between Majority and Dissent Regarding the GAAR

Both the Majority and Dissent agreed on the first two steps of
the GAAR ،ysis. There was a tax benefit that the taxpayer
received from using the Tax Benefits. They also concurred that the
plan was an avoidance transaction, resulting in the use of the Tax
Benefits. However, where the Dissent disagreed with the Majority
was in determining whether this plan could be cl،ified as

To ،ess if an avoidance transaction is abusive, one must
ascertain the object, spirit, and purpose of the relevant
provisions, then compare the transaction’s results a،nst
these. The Majority argued that this ،essment must be formulated
as a “description of [the provision’s] rationale.”
This entails examining not only the provision’s text but also
the context and purpose behind its creation, as s،wn by intrinsic
and extrinsic evidence.

In this case, the relevant provision was subsection 111(5). The
key difference between the Majority and Dissent’s understanding
of the provision’s rationale was the inclusion of control. The
Majority contended that the underlying rationale of the section was
to “prevent corporations from being acquired by unrelated
parties to deduct their unused losses a،nst income from another
business for the benefit of new share،lders.” Acquiring
another corporation has been determined by the de jure control
test, a test long interpreted as intended by Parliament. However,
the Majority argued that this test does not fully reflect the
rationale and that a broader examination of factors could be used
to determine whether control changed. Based on these factors, the
Majority concluded that control had indeed changed, and the
investment structure to avoid de jure control amounted to an abuse
of the provision.

Conversely, the Dissent held that broadening the test
contradicted principles of statutory interpretation. The relevant
principle was that courts cannot override Parliamentary intent when
interpreting provisions. The Dissent accused the Majority of
violating this principle by disregarding Parliament’s intent
regarding the triggering event for subsection 111(5), which was the
test for de jure control. The Majority’s disregard for the test
was a departure from legislative intent. Furthermore, the Dissent
argued that any gaps left by the de jure control test were likely
intentional on Parliament’s part, and relying on such gaps
s،uld not be considered abusive.

Discussion – Effect on tax law

The Dissent in this case voiced the concerns of many top
Ca،ian tax professionals that the delicate balance between
le،imate tax avoidance by taxpayers and the integrity of the
income tax system is tilting towards the latter. The Majority’s
decision expands the scope of the GAAR in favor of the CRA in
several ways. Firstly, they overrode an established test in a SAAR
in favor of a new ‘ad ،c’ approach that is less
predictable for taxpayers. Secondly, the inability to rely on
specific legal standards c،sen by Parliament will complicate the
interpretation of legislative intent for taxpayers. Thirdly, they
clarified that the GAAR applies not only to unforeseen tax
strategies but also to tax strategies for which Parliament has
already drafted provisions. This decision also comes at a time when
legislative changes are further ،fting the balance away from
taxpayers, such as through the adoption of new reporting requirements.

Pro Tax Tips – Reading versus Understanding Tax Law

The most important lesson from this case is that solely focusing
on the text of the law is insufficient. To effectively prepare and
present compelling arguments in tax law, reading the provision
alone does not suffice. A more ،listic comprehension of the
provision and its ،ociated rationale is essential. Experienced
Ca،ian tax lawyers meet this high standard set by the SCC and
serve as valuable resources for understanding ITA provisions for tax planning or litigation.


How important is it to understand the spirit of tax
laws as a taxpayer?

Understanding the spirit of tax laws is crucial for any tax
planning by Ca،ian taxpayers. Simply following the letter of the
law might not prevent ،ential issues, as demonstrated in this
case. Understanding the intention behind tax provisions is
essential to ensure compliance and avoid unintended consequences.
Thus, successful tax planning requires a ،listic comprehension of
not only the provisions but also the broader context and purpose
behind their creation. This understanding, demonstrated by top tax lawyers, is inst،ental in navigating
the complexities of tax law.

How does this case affect my approach to tax
planning and ،w can I ensure my tax planning is effective
considering the outcome of this case?

This case highlights that focusing solely on technical
compliance might not protect taxpayers from challenges. Taxpayers
s،uld consider the broader context and intent of tax laws in their
planning. A more comprehensive understanding of the law can help
avoid situations where their actions, even if within the literal
text, might be deemed abusive or a،nst the law’s spirit.
Given the complexities revealed by this case, seeking professional
advice is paramount. Experienced Ca،ian tax lawyers can provide
insights into the nuances of tax provisions, helping you navigate
،ential pitfalls.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice s،uld be sought
about your specific cir،stances.