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Dealing with the Death of a Duke:

The Need to Limit the Economic

Substance Principle in

Canadian Tax Law

By: Alexander Chan

MTAX 638 – Research Paper

April 23, 2007

Prof. Robin MacKnight

Mtax Research Paper MTAX 638 by Alexander Chan

1

TABLE OF CONTENTS

Introduction 2

Death of a Duke – the Silent Repudiation of the Duke of Westminster 3

The three principles of the Duke of Westminster 3

Rejection of the “economic substance” doctrine 4

If a taxpayer is not caught under the letter of the statute, 6

then that statute shall not apply

Rejection of a business purpose test 8

Canadian Jurisprudence 9

Stubart Investments Ltd. v. R. (“Stubart”) 9

Bronfman Trust v. R. (“Bronfman”) 12

Shell Canada Ltd. v. R. (“Shell”) 13

The General Anti-Avoidance Rule 14

The GAAR vs. Duke 16

Economic Substance 16

Letter of the Law 17

Freedom to arrange affairs 19

Status of the Duke Today 20

International views of the Duke 22

Conclusion – The Duke is Dead 26

The Duke’s Legacy – Relevance of the Duke’s to Economic Substance 27

Support for the application of economic substance 29

Support against economic substance 33

Conclusion 37

Recommendations 38


2

Introduction

Hugh Richard Arthur Grosvenor made a name for himself as a lover, a fighter,

and an Olympic athlete1, so it should come as no surprise that he also made a name for

himself in the world of Tax. Hugh Grosvenor, more commonly known as the second

Duke of Westminster, lived an eventful life, serving in the Second Boer War and World

War I, and competing in the 1908 Summer Olympics. It is also reported that he was

Coco Chanel’s lover for a five-year period starting in 1925. However, for most tax

professionals, he is probably most well known for his case against the Inland Revenue

Commission (“IRC”) concerning the deductibility of payments made to his servants.

The case of Duke of Westminster2 (“Duke”) is oft-cited as support against

attempts by revenue authorities to levy tax where the language of the taxing provision

does not squarely apply to a taxpayer’s situation. Elevated to a ‘central principle’ of tax

law, it has been referred to by courts in a near-reverent tone, as an almost incontrovertible

truth. However, in recent years, tax jurisprudence has seen a shift in the landscape

towards application of economic substance analysis, and the court’s reliance on Duke has

become contradictory and confusing.

In Canada, with the development of the General Anti-Avoidance Rule (“GAAR”)

and the slow introduction of economic substance, I would argue that Duke is no longer

good law in spite of the court’s blind statements that Duke has not been overruled.

In this paper, I hope to explore whether Duke has been over-ruled, and whether

the principles espoused in Duke continue to be valid. I will also examine whether and

1 http://en.wikipedia.org/wiki/Hugh_Grosvenor%2C_2nd_Duke_of_Westminster, (Last accessed: April 18,

2007) 2 Duke of Westminster v. Commissioners Of Inland Revenue, [1936] AC 1, [1935] All ER Rep 259, 51 TLR

467, 19 Tax Cas 490


3

how the principles in Duke should inform us in determining how economic substance

analysis should be applied.

Death of a Duke – the Silent Repudiation of the Duke of Westminster

The three principles of the Duke of Westminster v. IRC

Since it was handed down in 1935, the House of Lords decision in Duke has been

often cited in cases concerning tax minimization attempts by a taxpayer. Subsequent

cases have described Duke as setting down a “cardinal principle”3 of tax law. However,

although many authors and cases have referred to the Duke, few have fully analyzed the

case to determine precisely what principles have been set out in this landmark case.

The case itself dealt with an innovative remuneration scheme the duke set up for

some of his staff. The duke set up annuities for his servants, which would pay each of

them a set periodic fee. At the same time, the duke reduced the wages paid to the

servants by a similar amount, so that the employees would receive a similar amount of

remuneration under the new setup. The annuities were not a direct replacement, as the

employees would still be entitled to make a legal claim for wages for services rendered.

However, the duke fully expected and expressed his hope to the employees that they

would be happy with the amounts they would receive under the annuity.

Why did the duke set up this alternate form of remuneration? Simply put, this

was an attempt to save taxes. Under the prevailing tax act, payments made under an

annuity would be deductible from income for the purposes of determining liability for

surtax, whereas payments in the form of wages would not be deductible.

3 Craven v. White, [1989] AC 398, at 514 (HL)


4

Inland Revenue objected, primarily on the grounds that the payments were the

same as wages in substance, even though the legal form of the payments were as

annuities. Thus the issue was whether the courts could consider the economic substance

of the transaction, or whether they were limited to the legal form of the transactions or

transactions.

The case was appealed to the Tax Court, which maintained that these amounts

were not deductible. A key determination was arrived at by considering the true effect

and substance of the payments. The Judge stated,

“Looking, not at the form, but at the substance, of the thing, this must be

regarded, in the case of the servants remaining in His Grace's employ, as

wages.”.4

This was further appealed to the House of Lords. On a thorough analysis, three main

points can be distilled from the reasoning of the House of Lords.

Rejection of the “economic substance” doctrine

Generally stated, it is not permissible to re-characterize legal relations on the basis

that the substance of the transaction or series of transactions results in a different ‘effect’.

This was expressed in two different ways by the judges in Duke, but in essence, they said

the same thing.

Lords Tomlin, Russell, Harnsworth and Slesser were of the mind that although

“substance” was something that could be considered in construing a document, absent a

sham, the legal effect of the document could not be overridden.

4 Duke, supra, at 507.


5

Lord Tomlin noted some concern over the court’s trend towards applying the

doctrine of substance to a transaction,

“Apart, however, from the question of contract with which I have dealt it is said

that in Revenue cases there is a doctrine that the Court may ignore the legal

position and regard what is called "the substance of the matter" and that here the

substance of the matter is that the annuitant was serving the Duke for something

equal to his former salary or wages and that, therefore, while he is so serving, the

annuity must be treated as salary or wages. This supposed doctrine (upon which

the Commissioners apparently acted) seems to rest for its support upon a

misunderstanding of language used in some earlier cases. The sooner this

misunderstanding is dispelled and the supposed doctrine given its quietus the

better it will be for all concerned, for the doctrine seems to involve substituting

"the uncertain and crooked cord of discretion" for "the golden and straight mete

wand of the law".5

The rejection of the substance doctrine was echoed by Lord Russell,

“If, on the other hand, the doctrine means that you may brush aside deeds,

disregard the legal rights and liabilities arising under a contract between parties,

and decide the question of taxability or non-taxability upon the footing of the

rights and liabilities of the parties being different from what in law they are, then I

entirely dissent from such a doctrine.”.6

Although they accepted the idea that the substance of a transaction could be considered,

they chose to limit the application of any consideration of substance.

5 Ibid, at 520.

6 Ibid, at 524.


6

Lord Wright went one step further, and rejected the “substance” doctrine outright,

stating,

“And once it is admitted that the deed is a genuine document, there is in my

opinion no room for the phrase "in substance". Or, more correctly, the true nature

of the legal obligation and nothing else is "the substance".”7

This may have over-stated the case against the issue of substance, as the majority of the

House did recognize some value to the examination of substance, at least, as an

interpretive aid in construing a document. Nevertheless, these two views of substance

can be reconciled into a single point. Regardless of whether the court decides to

recognize the ‘economic substance’ of a document or whether the court chooses to stay

within the “four corners” of a document, the House agreed that it is not permissible to re-

characterize the legal effect of that document.

If a taxpayer is not caught under the letter of the statute, then that statute shall not apply

Interpretation of a statute at the time that Duke was heard would likely be

described as a highly formalistic one, with heavy emphasis on the words. Well before the

introduction of methods such as plain-meaning or words-in-total-context, legislation and

legal documents were viewed in a very black-or-white context.

The prevailing view could be traced to two quotes from Bradford v. Pickles. As

per Lord Halsbury,

“If it was a lawful act, however ill the motive might be, he had a right to do it. If it

was an unlawful act, however good his motive might be, he would have no right

to do it.”.8

7 Ibid, at 529.


7

And Lord Watson stated,

“No use of property, which would be legal if due to a proper motive, can become

illegal because it is prompted by a motive which is improper or even malicious.”.9

Returning to the ratios in Duke, Lord Russell, quoting the old English case of Partington,

stated the basic principle as it applied to the taxation statutes,

“As Lord Cairns said many years ago in Partington v. Attorney-General, (1869)

L.R. 4 E. & I.App.H.L. 100, at page 122: "As I understand the principle of all

fiscal legislation, it is this: If the person sought to be taxed comes within the letter

of the law he must be taxed, however great the hardship may appear to the judicial

mind to be. On the other hand, if the Crown, seeking to recover the tax, cannot

bring the subject within the letter of the law, the subject is free, however

apparently within the spirit of the law the case might otherwise appear to be."”.10

Taken together, these decisions follow the rule that the courts are to look at the “letter of

the law” and if the taxpayer falls within that language, the law will apply. If the taxpayer

does not fall within the language, the law will not apply. From the taxpayer’s viewpoint,

the objective would be then to fall squarely under the words of a relieving provision,

while avoiding any taxing provisions.

Lord Tomlin tied this view to the application of economic substance, and stated,

“This so-called doctrine of "the substance" seems to me to be nothing more than

an attempt to make a man pay notwithstanding that he has so ordered his affairs

that the amount of tax sought from him is not legally claimable.”.11

8 Bradford Corporation v. Pickles, [1895] A.C. 587 at 594.

9 Ibid, at 598.

10 Duke, supra, at 524.

11 Ibid, at 520.


8

A common theme running through the comments by Tomlin, Russell and MacMillan is

that there is a tinge of an adversarial relation between the taxpayer and the revenue

authority. Money earned by a taxpayer is a taxpayer’s to keep, unless the government

can take it away. However, this is not a general power to tax, rather the government is

required to be as precise as possible. If the words of the taxing statute are insufficient to

bring the taxpayer under the Act, then the taxpayer is perfectly free to avoid the tax.

Rejection of a business purpose test

Perhaps the most common quote from Duke is from Lord Tomlin, who stated,

“Every man is entitled if he can to order his affairs so that the tax attaching under

the appropriate Acts is less than it otherwise would be. If he succeeds in ordering

them so as to secure this result, then, however unappreciative the Commissioners

of Inland Revenue or his fellow tax-payers may be of his ingenuity, he cannot be

compelled to pay an increased tax.”.12

Thus the House of Lords gave explicit recognition to a taxpayer’s right to arrange his

affairs in accordance with a motivation to reduce or avoid tax. It is not amoral for a

taxpayer to want to pay less tax. As long as the taxpayer does not take illegal measures

to do so, Duke stands for the proposition that there is nothing wrong with this.

Thus pursuit of a particular arrangement with the express intention to reduce tax

was sanctioned by the House of Lords in Duke. The corollary to this principle is that

there is no requisite business purpose to any transaction or series of transactions carried

out by the taxpayer. Although this was not stated, it follows logically from Tomlin’s

statement.

12

Ibid, at 520.


9

These three principles represent the legacy that Duke provided to common law tax

jurisprudence, not only in Canada and the UK, but also many of the other Commonwealth

countries such as Australia, New Zealand. Although all three principles are rarely

discussed together when reference is made to Duke, they have been followed in their

individual forms in numerous cases subsequent to Duke.

Canadian Jurisprudence

Canadian jurisprudence has been especially reliant on the findings in Duke, never

daring to disagree.

Stubart Investments Ltd. v. R. (“Stubart”)

The modern day line of cases regarding tax avoidance begins with the Supreme

Court decision in Stubart.13

Stubart dealt with a series of transactions designed to utilize

losses in one corporation by the transfer of business assets from a profitable business.

The vendor continued to operate the business, albeit on the purchaser’s behalf, and paid

the net income to the purchaser, who then claimed the losses against that income.

Various agreements were signed that allowed the profitable business to return to the

original owner after the loss carry forwards were depleted.

The Ministry of National Revenue objected to this arrangement, and denied the

deduction of the prior year losses on the grounds that the income belonged to the vendor,

not the purchaser.

13

Stubart Investments Ltd. v. R., [1984] C.T.C. 294, 53 N.R. 241, [1984] 1 S.C.R. 536, 10 D.L.R. (4th) 1,

84 D.T.C. 6305, 15 A.T.R. 942 (S.C.C.)


10

Wilson J made reference to Lord Tomlin’s dictum in Duke that a taxpayer is free

to arrange his affairs, and argued that the Revenue’s position introduced a business

purpose test, and would reject the holdings in Duke,

“A transaction may be effectual and not in any sense a sham (as in this case) but

may have no business purpose other than the tax purpose. The question then is

whether the Minister is entitled to ignore it on that ground alone. If he is, then a

massive inroad is made into Lord Tomlin's dictum that “Every man is entitled if

he can to order his affairs so that the tax attaching under the appropriate Acts is

less than it would otherwise be”: IRC v. Duke of Westminster, (supra), at 19.

Indeed, it seems to me that the business purpose test is a complete rejection of

Lord Tomlin's principle.”.14

Wilson J went on to say,

“I think Lord Tomlin's principle is far too deeply entrenched in our tax law for the

courts to reject it in the absence of clear statutory authority.”.15

Estey J also considered Duke in his decision, and conducted a thorough analysis of the

state of statutory interpretation in light of Duke. Although he did not indicate as strong

an endorsement for Duke as Wilson J, Estey J did reject the business purpose test,

“I would therefore reject the proposition that a transaction may be disregarded for

tax purposes solely on the basis that it was entered into by a taxpayer without an

independent or bona fide business purpose.”.16

However, it should be noted that although the decision did not expressly reject Duke,

there were some inconsistencies with the principles outlined in Duke.

14

Stubart, supra, at para. 71. 15

Ibid, at para. 72. 16

Ibid, at para. 55.


11

On the issue of application of the strict letter of the law to taxation statutes, Estey

had the following to say,

“In all this, one must keep in mind the rules of statutory interpretation, for many

years called a strict interpretation, whereby any ambiguities in the charging

provisions of a tax statute were to be resolved in favour of the taxpayer; the taxing

statute was classified as a penal statute.”.17

“The converse was, of course, also true. Where the taxpayer sought to rely on a

specific exemption or deduction provided in the statute, the strict rule required

that the taxpayer's claim fall clearly within the exempting provision, and any

doubt would there be resolved in favour of the Crown… Indeed, the introduction

of exemptions and allowances was the beginning of the end of the reign of the

strict rule.”.18

Very little was said about economic substance, and whether substance was relevant in re-

characterizing the legal form of the transactions. This is curious, as the arrangements in

Stubart would appear to be a clear example where the economic substance differed from

the legal effect. The court did not support the principle in Duke by expressly repudiating

any attempt to use the doctrine of substance to over-ride the legal form. It is true that in

effect, the court did refuse to apply economic substance, but it raises the suspicion as to

why the court did not take the opportunity to deal with the economic substance doctrine

when there was a clear call to do so.

As early as Stubart, the seeds of the Duke’s demise had been planted. I submit

that the Supreme Court in Stubart failed to recognize that the Duke stood for more than

17

Ibid, at para. 57. 18

Stubart, at para. 59.


12

one principle, and also failed to support some of the tenets that were set out in that

decision. Taken further, in the case of “strict interpretation of the letter of the law”,

Stubart demonstrated a rejection of at least one of the three principles of Duke.

Bronfman Trust v. R. (“Bronfman”)

The case of Bronfman19

dealt with the deductibility of interest payments made to

enable a trust to make capital allocation payments to its beneficiaries. Although it dealt

with the interest deductibility provisions in paragraph 20(1)(c), the decision by Dickson

CJ is notable for obiter dicta concerning the applicability of economic substance in

interpreting taxation statutes. Dickson CJ stated,

“I acknowledge, however, that just as there has been a recent trend away from

strict construction of taxation statutes (see Stubart Investments Ltd. v. The Queen,

[1984] 1 S.C.R. 536 at 573–79: [1984] C.T.C. 294 at 313–316 and The Queen v.

Golden, [1986] 1 S.C.R. 209 at 214–15; [1986] 1 C.T.C. 274 at 277), so too has

the recent trend in tax cases been towards attempting to ascertain the true

commercial and practical nature of the taxpayer's transactions. There has been, in

this country and elsewhere, a movement away from tests based on the form of

transactions and towards tests based on what Lord Pearce has referred to as a

“common sense appreciation of all the guiding features” of the events in

question…

This is, I believe, a laudable trend provided it is consistent with the text and

purposes of the taxation statute. Assessment of taxpayers' transactions with an eye

19

Bronfman Trust v. R., [1987] 1 C.T.C. 117, 71 N.R. 134, 25 E.T.R. 13, [1987] 1 S.C.R. 32, 36 D.L.R.

(4th) 197, 87 D.T.C. 5059 (S.C.C.)


13

to commercial and economic realities, rather than juristic classification of form,

may help to avoid the inequity of tax liability being dependent upon the taxpayer's

sophistication at manipulating a sequence of events to achieve a patina of

compliance with the apparent prerequisites for a tax deduction.”.20

Dickson CJ did not make any reference to overruling Duke, but again, the Supreme Court

showed a willingness to challenge one of the central tenets of Duke.

Shell Canada Ltd. v. R. (“Shell”)

In Shell21

, the Supreme Court also considered a situation where the economic

substance of a series of transactions resulted in a tax savings. McLachlin J stated,

“This Court has repeatedly held that courts must be sensitive to the economic

realities of a particular transaction, rather than being bound to what first appears

to be its legal form: Bronfman Trust, supra, at pp. 52-53, per Dickson C.J.;

Tennant, supra, at para. 26, per Iacobucci J. But there are at least two caveats to

this rule. First, this Court has never held that the economic realities of a situation

can be used to recharacterize a taxpayer's bona fide legal relationships.”.22

“Inquiring into the “economic realities” of a particular situation, instead of simply

applying clear and unambiguous provisions of the Act to the taxpayer's legal

transactions, has an unfortunate practical effect. This approach wrongly invites a

rule that where there are two ways to structure a transaction with the same

economic effect, the court must have regard only to the one without tax

advantages. With respect, this approach fails to give appropriate weight to the

20

Ibid, at paras. 48-49. 21

Shell Canada Ltd. v. R., [1999] 3 S.C.R. 622, [1999] S.C.J. No. 30 (S.C.C.) 22

Ibid, at para. 39.


14

jurisprudence of this Court providing that, in the absence of a specific statutory

bar to the contrary, taxpayers are entitled to structure their affairs in a manner that

reduces the tax payable: Stubart, supra, at p. 540, per Wilson J., and at p. 557, per

Estey J.; Hickman Motors Ltd. v. R., [1997] 2 S.C.R. 336 (S.C.C.) at para. 8, per

McLachlin J.; Duha, supra, at para. 88, per Iacobucci J.; Neuman, supra, at para.

63, per Iacobucci J. An unrestricted application of an“ economic effects”

approach does indirectly what this Court has consistently held Parliament did not

intend the Act to do directly.”.23

It should be noted that Shell, like Bronfman, did not cite Duke. However, with this

decision, life appeared to breathe back into Duke, as the court expressly addressed with

approval two of the three tenets of the Duke. Namely, economic substance cannot be

used to re-characterize legal transactions, and a taxpayer is generally free to structure

affairs in a way that reduces the amount of tax payable.

The General Anti-Avoidance Rule

Although a general anti-avoidance rule of sorts had existed in the Act under

section 137 of the Income Tax Act, RSC 1952, c.148, it did not generate as much

litigation as its current incarnation. The GAAR, aside from a minor modification in 2004

to remove a double negative, was incorporated into the Act in 1988, primarily in response

to the decision in Stubart.

23

Ibid, at para. 36.


15

The proper approach to the application of the GAAR was set out in McLachlin J’s

decision in Canada Trustco24

. Although it has been discussed numerous times in other

scholarship, I will briefly discuss the approach here. McLachlin CJC applied a three-step

test.

First, the court will examine whether there is a tax benefit that results from the

transactions or the series of transactions. A tax benefit is defined in the Act in subsection

245(1),

“tax benefit” means a reduction, avoidance or deferral of tax or other amount

payable under this Act or an increase in a refund of tax or other amount under this

Act, and includes a reduction, avoidance or deferral of tax or other amount that

would be payable under this Act but for a tax treaty or an increase in a refund of

tax or other amount under this Act as a result of a tax treaty;25

This aspect of the analysis is generally fairly straight-forward.

Second, if there is a tax benefit, the court makes an inquiry as to whether the

transaction or series of transactions constitute an avoidance transaction. An avoidance

transaction is defined in subsection 245(3),

“An avoidance transaction means any transaction

(a) that, but for this section, would result, directly or indirectly, in a tax

benefit, unless the transaction may reasonably be considered to have been

undertaken or arranged primarily for bona fide purposes other than to

obtain the tax benefit; or,”26

24

Canada Trustco Mortgage Co. v. R., [2005] 5 C.T.C. 215, 340 N.R. 1, 259 D.L.R. (4th) 193, [2005] 2

S.C.R. 601 (S.C.C.) 25

Subsection 245(1) “tax benefit” of the Act. 26

Paragraph 245(3)(a) of the Act.


16

Therefore, the court must look at the underlying reason and purpose to the transaction. In

other words, the court goes beyond the legal nature of the transaction, and looks for a

‘non-tax’ purpose. It becomes evident that an economic substance analysis becomes

relevant in this endeavor, since the economic result or ‘actual result’ will be one of the

factors the court will look at in order to discern the true purpose of the transaction.

Finally, if a transaction is an avoidance transaction, the court will examine

whether there has been a misuse of the provisions or abuse of the act as a whole. In order

to do so, the court will look to the Parliament’s intention when they drafted the particular

provision that the taxpayer has relied upon, and compare the intention with the taxpayer’s

use of those provision.

If the GAAR is found to be applicable, s. 245(2) allows the court to deny the tax

benefit. The effective result is that the legal relations and transactions the taxpayer has

will be re-characterized for tax purposes.

The GAAR vs. Duke

With the development of the GAAR in the courts, it is time to revisit our views of

the Duke case, and consider whether the principles in Duke continue to be valid.

Economic Substance

One of the key tenets of Duke is that it is not permissible to re-characterize validly

executed legal relations and transactions based on an analysis of the underlying economic

substance. A stronger statement is that Duke stands for the proposition that economic


17

substance should not even be considered, and that only the legal effect is relevant in

determining taxability.

However, ss.245(2) clearly allows the court to disregard the legal form of a

transaction where the avoidance transaction is found to be a misuse or abuse. Although

the GAAR will not re-characterize the transaction for legal purposes, it will re-

characterize the transaction for tax purposes.

Letter of the Law

As did Lord Russell, Lord MacMillan followed a strict interpretation in Duke, and

agreed with the philosophy that the strict letter of the law should prevail in determining

taxation,

“I am fully conscious of the anomalous consequences which might conceivably

arise in other connections from the course adopted by the Respondent, but your

Lordships are concerned only with the technical question whether the Respondent

has brought himself within the language of the Income Tax rule as to contractual

payments, and I think that he has succeeded in doing so. That is enough for the

decision of the case.”.27

The development of the purposive style of interpretation in Stubart introduced a

movement away from the strict interpretation of taxation statutes. However, crafty

taxpayers were still given some freedom to plan around the legislation.

In response, the GAAR was designed to put at end to the continual ‘arm’s race’

between the Department of Finance (“Finance”), the Canada Revenue Agency (“CRA”)

and the taxpayer. Prior to the GAAR, the traditional dance was one where the taxpayer

27

Duke, supra, at 527.


18

would identify a loophole and then design a plan to capitalize on that loophole to avoid

the strict letter of the law. The response was then to ‘patch’ up the Act with legislation

that directly addressed the loophole. Then the taxpayer would adjust the transaction to

avoid the new legislation, forcing Finance to put in another patch. This was addressed by

Estey J in Stubart,

“These interpretative guidelines, modest though they may be, and which fall well

short of the bona fide business purpose test advanced by the respondent, are in my

view appropriate to reduce the action and reaction endlessly produced by

complex, specific tax measures aimed at sophisticated business practices, and the

inevitable, professionally-guided and equally specialized taxpayer reaction.”.28

With the GAAR, it cannot be said that if a taxpayer falls outside the letter of the law that

the taxpayer is therefore free from tax on that transaction. If a taxpayer can avoid the

words of the provision, and not get caught, there is still the chance that the GAAR that

can apply (assuming it is an avoidance transaction that misuses or abuses the provisions

of the Act). As a result, even avoiding the letter of law does not avoid tax.

A subtle argument can be made that the taxpayer in the above situation is still

avoiding the letter of the law with respect to the original provision, as there is no tax

based on that provision. The tax liability does not result from that section, but rather from

the GAAR, and in order for the GAAR to apply, the taxpayer is falling within the letter of

the law of the GAAR.

Although technically correct, this misses the point. If the tax benefit is denied

under ss.245(2), the proper calculation of tax will be in reference to proper use of the

provision that has been misused. If the avoidance is one where the words of a taxing

28

Stubart, at para. 66.


19

provision are avoided, then the GAAR will make that provision apply. If the avoidance

is one where the taxpayer falls under the words of a relieving provision, then the GAAR

will re-characterize the transaction so that the provision does not apply. In either case,

the ‘letter of the law’ principle is not valid under the GAAR.

Another point to be made is the operation of the GAAR looks to the intention of

the provisions at play. As a result, not only is the letter of the law relevant, but also the

background and intention. Thus, not only has the ‘letter of the law’ principle been

avoided when considering a technical application of the GAAR, even the approach to the

GAAR expressly recognizes that the ‘letter of the law’ is no longer the end all and be all.

Freedom to arrange affairs

Possibly the most common quote from Duke is Lord Tomlin’s statement, which

bears repeating here,

“Every man is entitled if he can to order his affairs so that the tax attaching under

the appropriate Acts is less than it otherwise would be.”.29

Under the GAAR, there is no restriction on a taxpayer’s affairs in an economic sense. A

taxpayer is free to conduct his business or affairs in any desired manner, as long as it is

lawful. However, the GAAR does place a restriction on a taxpayer in arranging its legal

affairs, at least in respect of tax. With the re-characterization that is possible under the

GAAR, in order for a taxpayer’s legal relationships to be respected, these legal

relationships must match the economic relationships.

This point requires clarification. Under Duke, the taxpayer is free to arrange its

legal affairs even though the underlying economic relationships are not properly

29

Duke, supra, at 520.


20

reflected, short of any sham transaction. However, if this is attempted under the GAAR,

the courts will look to the economic relationship to determine the purpose of the

transactions. Assuming all the other requirements of the GAAR are met, the transaction

can be re-characterized on the basis of that economic relationship, and the tax benefit

denied.

As a result, the legal relationship and the economic relationship must match to

ensure that the legal relationships are given their full effect under the law. However, if

they do not match, the court is open to apply (where valid) GAAR to re-characterize that

legal relationship, and examine the transactions on their economic substance for tax

purposes.

So is the taxpayer still free to arrange his affairs? The answer is yes, but with a

strong caveat. The taxpayer is free to arrange his economic affairs. Duke never

addressed this. But with the application of the GAAR, the taxpayer is no longer free to

arrange his legal affairs in any manner. The freedom to arrange legal affairs has been

significantly narrowed by the requirement to avoid the GAAR.

Status of the Duke Today

Much of Canadian tax jurisprudence supports the principles laid out in Duke, at

least on their face. I can find no cases in Canadian tax law that expressly overrule Duke.

In fact, even to this day, the courts continue to state that the Duke is still good law.

In Canada Trustco,

“According to the Explanatory Notes, Parliament recognized the Duke of

Westminster principle “that tax planning — arranging one's affairs so as to attract


21

the least amount of tax — is a legitimate and accepted part of Canadian tax law”

(p. 464). Despite Parliament's intention to address abusive tax avoidance by

enacting the GAAR, Parliament nonetheless intended to preserve predictability,

certainty and fairness in Canadian tax law. Parliament intends taxpayers to take

full advantage of the provisions of the Income Tax Act that confer tax benefits.

Indeed, achieving the various policies that the Income Tax Act seeks to promote

is dependent on taxpayers doing so.”

Some commentators suggest that the GAAR is inconsistent with Duke, and that courts are

getting it wrong by continuing to apply Duke principles,

“The general anti-avoidance rule is clearly inconsistent with the Duke of

Westminster principle. Under section 245 ¨ ¨, a taxpayer is not entitled to arrange

his affairs to minimize tax unless the transaction is carried out primarily for bona

fide non-tax purposes, or, if the transaction is carried out primarily for tax

purposes, unless it does not result in a misuse of the provisions of the Act or an

abuse having regard to the provisions of the Act read as a whole. If the Supreme

Court does not recognize the fundamental inconsistency between the Duke of

Westminster principle, which is so deeply entrenched in its jurisprudence, and the

new general anti-avoidance rule, it is likely to misconstrue the general anti-

avoidance rule.”.30

I would go one step further and submit that with the development of the GAAR in cases

like Canada Trustco, Mathew31

, and Evans32

, the inconsistency is clear, and the courts in

30

Brian J. Arnold, "Reflections on the Relationship Between Statutory Interpretation and Tax Avoidance,"

(2001), vol. 49, no. 1 Canadian Tax Journal, 1-39, at p. 30. 31

Mathew v. R., 2005 SCC 55, 2005 D.T.C. 5538 (Eng.), 2005 D.T.C. 5563 (Fr.), [2005] 5 C.T.C. 244, 339

N.R. 323, 259 D.L.R. (4th) 225 (S.C.C.)


22

application of the GAAR have already overruled Duke, albeit silently under the cover of

darkness. Proper application of the GAAR as per McLachlin J in Canada Trustco

expressly rejects the last two principles of Duke, and places heavy restrictions on the first.

It is difficult to understand why the court has decided to take this inconsistent

view of the Duke. The easy answer is that Duke has found support for decades of

Canadian tax jurisprudence, and perhaps under a perceived need to follow stare decisis

the courts are loathe to reject it.

However, I would speculate that the basic principles in Duke make sense and still

hold value, even in light of the GAAR. The courts recognize this, and pay a great deal of

lip service to indicate their adherence to the Duke (and therefore to the basic principles)

on one hand, while making rulings that contradict these principles on the other hand. I

submit that the GAAR has developed in such a way that the Duke principles have been

overruled, and that creates discomfort on the part of the courts because it is difficult to

reject the principles that make sense.

International views of the Duke

Canada appears not to be the only jurisdiction trying to hold on to the principles

in Duke. In the United Kingdom, the courts have been slowly been relinquishing their

reliance on Duke, yet courts continue to work to maintain Duke as good law.

The House of Lords case of Ramsay33

signaled the first deviation from the

principles in Duke. In Ramsay, the court considered a tax planning scheme whereby

losses were generated, which would then be set off against a capital gain. Although each

32

Evans v. R., 2005 TCC 684, 2005 D.T.C. 1762 (Eng.), [2006] 2 C.T.C. 2009, [2005] T.C. 581 (T.C.C.) 33

W. T. Ramsay Ltd. v. IRC, [1981] 1 All ER 865 (HL).


23

step in the plan was legally effective, the steps were self-cancelling, and views as a

whole, neither a gain nor a loss was created. In considering whether the steps were to be

examined individually or whether the steps taken as a whole could be examined, Lord

Wilberforce attempted to narrow Duke,

“Given that a document or transaction is genuine, the court cannot go behind it to

some supposed underlying substance. This is the well-known principle of Inland

Revenue Comrs v Duke of Westminster [1936] AC 1, 19 Tax Cas 49. This is a

cardinal principle but it must not be overstated or over-extended.”.34

Ramsay was followed by Furniss v. Dawson35

, which described the Ramsay doctrine as

an emerging principle of the law. Generally speaking, substance over form could be

applicable where the transactions at issue form a series. As per Lord Bridge,

“When one moves, however, from a single transaction to a series of inter-

dependent transactions designed to produce a given result, it is, in my opinion,

perfectly legitimate to draw a distinction between the substance and the form of

the composite transaction without in any way suggesting that any of the single

transactions which make up the whole are other than genuine.”.36

Similarly, in Craven, Lord Oliver addressed the relation between Duke and Ramsay,

“Both Lord Wilberforce and Lord Fraser emphasise the continued validity and

application of the principle of IRC v Duke of Westminster [1936]AC 1, 19 TC

490, a principle which Lord Wilberforce described as a 'cardinal principle'. What

it did decide was that that cardinal principle does not, where it is plain that a

particular transaction is but one step in a connected series of interdependent steps

34

Ibid. 35

Furniss v. Dawson, [1984] AC 474 (HL). 36

Ibid.


24

designed to produce a single composite overall result, compel the court to regard

it as otherwise than what it is, that is to say, merely a part of the composite

whole.”.37

Therefore, under the Ramsay doctrine, legally effective transactions could be set aside if

determined that they were part of a series of pre-ordained transactions and had no

commercial or business purpose other than the avoidance of tax. It appears that the Lords

attempted to distinguish this from Duke on the basis that Ramsay only applied to a pre-

ordained series of steps, and thus maintained that Duke was still good law.

This was confusing, as on a re-examination of Duke, it could be argued that the

Ramsay principle could apply as well. This contradiction led many commentators to

suggest that Ramsay represented the beginning of the end for Duke. I would agree, as

application of the Ramsay principle would violate all three principles of Duke.

More recent cases have questioned the validity of the Ramsay principle,

suggesting that in Ramsay, the particular result was due to a purposive approach to

statutory interpretation, and that the requirement of a pre-ordained series of steps was

merely an aid to interpretation, and not necessarily a hard and fast rule. Lord Nichols

explained this in MacNiven,

“…the Ramsay approach is no more than a useful aid. This is not an area for

absolutes. The paramount question always is one of interpretation of the particular

statutory provision and its application to the facts of the case. Further, as I have sought to

explain, Ramsay did not introduce a new legal principle. It would be wrong, therefore, to

set bounds to the circumstances in which the Ramsay approach may be appropriate and

helpful. The need to consider a document or transaction in its proper context, and the

37

Craven, supra.


25

need to adopt a purposive approach when construing taxation legislation, are principles of

general application.”38

However, Lord Hoffman suggested that perhaps Lord Tomlin’s statements in

Duke have been misinterpreted,

“My Lords, I venture to suggest that some of the difficulty which may have been

felt in reconciling Ramsay with IRC v Duke of Westminster [1936] AC 1, 19 TC

490 arises out of an ambiguity in Lord Tomlin's statement that the courts cannot

ignore 'the legal position' and have regard to 'the substance of the matter'. If 'the

legal position' is that the tax is imposed by reference to a legally defined concept,

such as stamp duty payable on a document which constitutes a conveyance on

sale, the court cannot tax a transaction which uses no such document on the

ground that it achieves the same economic effect. On the other hand, if the legal

position is that tax is imposed by reference to a commercial concept, then to have

regard to the business 'substance' of the matter is not to ignore the legal position

but to give effect to it.”.39

In essence, this suggests that considering economic substance is valid when looking at

issues that are considered to be commercial concepts. If such a concept is not a legally

defined construct, then looking at the true nature of the transaction or series of

transactions is fair game.

In Barclays, Lord Nicholls completed the rejection of Ramsay, stating,

38

MacNiven v. Westmoreland Investments Ltd., [2003] 1 AC 311, at para. 8 (HL). 39

Ibid, at para. 39.


26

“Cases such as these gave rise to a view that, in the application of any taxing

statute, transactions or elements of transactions which had no commercial purpose

were to be disregarded. But that is going too far.”.40

However, in rejecting the Ramsay principle, the House of Lords went on to apply the

modern day purposive approach to interpreting statutes, namely that the court would look

to see what the statute was intended to catch, and then look to see if the particular

transactions in question fell into the net. Otherwise, the court said little about what the

purposive approach actually was.

The problem with respect to the Duke, is that this does not restore the three

principles. Whether it is the application of the Ramsay principle, or a nebulous purposive

approach, a strict literal approach was rejected. It is no longer clear whether a taxpayer

can arrange his affairs. It does not appear that if a taxpayer avoided the letter of the law

that he would still necessarily avoid taxation. Finally, a purposive approach seems to

suggest that economic substance will be considered.

Conclusion – The Duke is Dead

The courts have been following the House of Lords decision in the Duke of

Westminster for over 70 years. The Duke of Westminster principle has been described

with such reverent terms such as ‘central principle’. However, on an examination of the

ratio in Duke, it becomes difficult to maintain that the Duke continues to be good law.

Part of the problem may stem from the fact that three separate but related

principles can be extracted from the decisions laid down by the Lords. As the courts

developed the modern day purposive approach to statutory interpretation, reliance on

40

Barclays Finance Ltd. v. Mawson, [2005] 1 AC 684, at para. 36 (HL).


27

these principles has begun to erode. Especially with the introduction of the GAAR, it can

be shown how each of these principles have either been rejected, or narrowed

significantly.

It is curious that the courts continue to express support for the Duke, while on the

other hand, their decisions express a rejection of the principles enunciated within. This

has not only occurred in Canada, but in other Commonwealth nations as well. Why have

the courts been so unwilling to directly overrule Duke, yet still reject the underlying

principles? Perhaps it stems from a misunderstanding of the decisions in Duke. Perhaps

it is a veiled recognition that the principles retain some value.

Even though it becomes clear that the Duke has slowly been overruled, the Duke

did not perish in vain. With an understanding of the underlying principles in Duke,

perhaps these values should assist us in the development of Canadian jurisprudence.

The Duke’s Legacy – Relevance of the Duke’s Principles to Economic Substance

The first half of this paper discussed the demise of the principles set out in the

Duke of Westminster case. Although the courts have attempted to hold on to the notion

that the central tenets of Duke have been maintained and not over-ruled, it has been

shown that through their decisions, the courts have indeed over-ruled Duke, if not

directly, then indirectly through the implication of their reasoning.

The second half of the paper takes the analysis to the next logical step. Assuming

that Duke is no longer good law, are there principles in Duke that we should keep? And

if so, does that shed light on any restrictive measures we should put on the application of

economic substance in the Act?


28

Let us re-iterate the three principles extracted from Duke:

(1) Every man is entitled to structure his affairs in order to reduce the amount of tax

that would otherwise be payable.

(2) If a taxpayer is not caught under the letter of the statute, then no tax shall result.

(3) It is not permissible to re-characterize legally effective transactions under

reasoning that the substance of the transaction is different.

It can be said that economic substance lies at the heart of each of these tenets. The first

principle is the opposite of a business purpose test as it allows a taxpayer to carry out a

tax-motivated transaction. But, if there is a business purpose test, then court will have to

look at the results of transactions and identify what the true effect is, in order to

determine what the business purpose is. The second principle represents a strict

interpretation. Economic substance is directly relevant to the letter of the law issue, as

determining taxation on the basis of economic substance is result if a strict interpretation

is rejected. The final principle is also closely related to economic substance, for if

allowed, re-characterization of legal relations would occur along the lines of what the

economic substance of the transaction would have otherwise yielded. Thus, if we accept

economic substance as a proper basis on which taxation can be decided, then we can say

that the principles outlined in Duke have been overruled. And with that, the Duke is

dead.

The question then remains whether it is appropriate to consider economic

substance in the interpretation of the tax legislation, and if so, are there any limitations


29

that should be placed upon the use of economic substance. Reference to the three tenets

outlined in Duke can assist in the analysis.

Support for the application of economic substance

The use of economic substance has been supported in the literature on a number

of grounds. For the purposes of analysis, it is assumed that economic substance would be

the remedy to tax planning. More often than not, successful tax planning relies on the

taxpayer being able to fall under a relieving provision, or out of a taxing provision. As

the introduction of economic substance analysis may re-characterize the taxpayer’s

position, forcing him out (or in, as the case may be) of the provision sought to be relied

upon, this would represent an obvious counter-measure to some forms of tax planning.

Consequently, for the purposes of this analysis, economic substance can be seen as the

government’s counter to tax planning.

Loss of Governmental Revenue

The most obvious effect of successful tax planning is less tax being exigible for

the taxpayer, whether it be by a reduction of tax, or a deferral of tax. The result is that

the government would collect less revenue. It is questionable whether the effect of tax

planning by a single taxpayer would have any significant effect on the fisc, however, in

the aggregate, there is logically some merit to this argument.

“In introducing the new anti-avoidance provisions, the government made it clear

that the GAAR "is an essential element in protecting the expanded tax base

against further erosion and stabilizing income tax revenues" and that "equity


30

requires that firm measures be taken to block sophisticated strategies designed to

yield tax advantages that were not intended by Parliament."”.41

Obviously, this would be a problem if the government budgeted the tax revenue into its

financial plans. A short fall in expected revenue from taxation could have a detrimental

effect on the government.

But the problem with this argument is that this would assume that the effects of

tax planning have not been factored into government fiscal planning. Tax planning has

been going on likely since the introduction of the Income War Tax Act in 1917, and has

been something that Finance is keenly aware of, and therefore, must have factored into

their budgeting. Consequently, refusing to apply economic substance to catch tax

planners would not have the grave results that some of the commentators suggest.

Rather, allowing economic substance would have the effect of giving the government a

windfall of tax revenue. As Finance has the power to levy additional taxes at its whim,

they do not need the assistance of a windfall in order to fatten up the government coffers.

It has also been argued that there is an element of unfairness if tax avoidance is

allowed to go unchecked, in that a tax planner would be able to avoid tax that would

otherwise be payable. However, this assumes that the tax “belongs” to the government in

the first place. Canada already has one of the highest levels of tax when compared to

other jurisdictions. An analysis of the proper levels of tax is beyond the scope of this

paper, but at first blush, high levels of tax suggest that the government already takes its

fair share, if not more than its fair share. With this in mind, it becomes unfair if we go in

with the mindset that the government is entitled to take even more.

41

Jinyan Li, ""Economic Substance": Drawing the Line Between Legitimate Tax Minimization and

Abusive Tax Avoidance," (2006), vol. 54, no. 1 Canadian Tax Journal, 23-56, at pg. 42.


31

Prejudice to Other Taxpayers

Another argument is that allowing tax planning is unfair to other taxpayers who

do not resort to tax planning. The arguments of unfairness are based on two lines of

reasoning. First, if the tax planner is able to avoid or reduce taxes, then it is said that he

is avoiding his ‘fair share’ of the taxes. Li stated,

“"Fairness" is a fundamental notion of tax policy. It certainly encompasses fair

treatment of individual taxpayers. But more importantly, fairness refers to fair

treatment of taxpayers as a whole.”.42

Similarly, discussing the effect on other taxpayers, Arnold said,

“The revenue lost must be made up from other taxpayers. These other taxpayers

are generally salaried employees and other taxpayers who have little opportunity

to engage in tax-avoidance transactions. The benefits of aggressive tax avoidance

belong to corporations and wealthy individuals who can afford professional

advice.”.43

The result being that other taxpayers would have to pay more taxes to pick up the slack.

Again, this assumes that the government has not factored it in.

Second, there could be vertical inequality, as only those taxpayers who are

sophisticated enough (or have the financial means) would have access to tax planning.

However, I don’t think taxpayers should be penalized for being sophisticated. Also,

technically everyone has the financial means to do tax planning. The difference is that in

many cases, it is not financially viable for a taxpayer to engage in tax planning activities

42

Li, at pg. 42. 43

Arnold, at 26.


32

because the cost and risk outweigh the benefit. When the benefit outweighs the cost and

risk, that taxpayer would be paying a high amount of tax in the first place, so it is difficult

to say that the high taxpayer would not be paying tax.

Parliamentary Congestion

A third argument in favour of economic substance is that it is necessary to reduce

parliamentary congestion. This is a direct application of the ‘arm’s race’ theory. Lord

Wilberforce addressed this point in Ramsay,

“While the techniques of tax avoidance progress and are technically improved, the

courts are not obliged to stand still. Such immobility must result either in loss of

tax, to the prejudice of other taxpayers, or to Parliamentary congestion or (most

likely) to both.”.44

However, it is not clear that Parliamentary congestion is such a bad result. The ‘hole and

plug’ method of drafting tax legislation is not just the result of taxpayers finding

loopholes in the law. A great deal of the blame falls on the drafters themselves for

constructing poorly written legislation. It is true that there are sophisticated tax planners

today who are able to keep the arm’s race going, but I submit that if the provisions in the

Act are well-thought out and well-drafted, and there would be less of this ‘dance’.

If the government wants to avoid this game, it should be incumbent on the

drafters of legislation to clearly think out the provisions that are intended to levy taxes on

taxpayers. There have been instances where Finance has drafted sections of the Act

fraught with inconsistencies and errors, with negative consequences. For example,

amendments in respect of the foreign affiliate rules on February 28, 2004 have appeared

44

Ramsay, at 181.


33

to create more problems then they have solved, and after rounds and rounds of

consultations with experts, these amendments still have not been passed. In the

meanwhile, taxpayers are left with a great deal of uncertainty, with three or possibly even

four sets of provisions that could possibly apply to a foreign affiliate transaction. This

introduces unnecessary risk, and increased transaction costs, as if would be foolhardy for

taxpayers to proceed with a particular transaction without determining all the possible tax

results. It is the drafting of legislation with errors, loopholes, and absurd results that

allows unpredictability and uncertainty to creep into the tax legislation.

It is true that tools such as economic substance analysis would reduce the

Parliamentary congestion, but this is a short-sighted and lazy solution to a problem that

proper construction of legislation should remedy.

Support against economic substance

Certainty and Predictability

The primary argument against economic substance and for a stricter interpretation

of taxation provisions is that certainty and predictability would be hampered. Some

commentators have questioned the need for certainty and predictability.

“The certainty argument is a favourite of tax practitioners and is easily made. This

argument is not analyzed by the Supreme Court; it is simply asserted.”.45

The easy answer is that without certainty and predictability, the tax effects of various

transactions would be in doubt. It would be naïve to think that in today’s sophisticated

business environment that taxes are not a significant factor in determining whether to go

45

Arnold, at pg. 27.


34

ahead with a transaction. If there is a tax risk attached to a transaction, a risk averse

taxpayer might simply avoid the transaction altogether. The result would then be the loss

of various economic activities that might otherwise be beneficial to the economy.

In a study of Tax Avoidance, the Tax Law Review Committee had the following

to say,

“However, we think that undue uncertainty as to the direction a judicial anti-

avoidance doctrine may follow is undesirable in taxpayer’s private and

commercial affairs and unsatisfactory also for the Government, which must

respond to avoidance activity long before the Courts are able to express their view

of particular arrangements.”46

Some may argue that economic substance is only meant to catch transactions with

no real economic substance, and would not catch those transactions that would be

beneficial to the economy, since these would likely have real substance. I would agree

with that intention, however, in practice, the uncertainty caused by economic substance

would cast a wider net than that.

A particular transaction would most likely be able to be carried out in a number of

manners. For example, let us say there is the baseline, and a reduced-tax alternative.

Without getting into specifics, with economic substance there is the possibility that the

reduced-tax alternative would be caught. Therefore, the only safe alternative for the

taxpayer to carry out the transaction would be to accept the baseline alternative.

Consequently, this means that the taxpayer would always pay maximum tax. This is

clearly not palatable, and if the taxpayer had other options (i.e. to carry out the

46

Tax Law Review Committee, “Tax Avoidance”, November 1997, The Institute for Fiscal Studies at pg.

x.


35

transaction in a different country), Canada might lose the transaction. If the taxpayer had

no other options, and the baseline would result in an unacceptable tax position, then the

taxpayer might simply refuse to proceed. In either case, a transaction would be lost that

would otherwise be beneficial to the economy.

The more difficult answer is that it is unfair to the taxpayer to live in a climate of

uncertainty. Especially if the taxpayer has a limited amount of resources, he cannot

properly allocate resources if the risks of each transaction are unknown. Predictability

and certainty reduces business risks.

Reins on Parliamentary Power

The power to tax lies in the hands of Parliament. They can choose to increase

taxes or decrease taxes as their own choice. Granted, this power cannot be used in a

capricious manner, as the recourse that taxpayers have, is to vote them out of power at the

next opportunity. However, until then, taxpayers do not have a great deal of power

against the government. If the government decides to legislate a harsh and unfair tax,

there is little that the taxpayer can do other than to pay the tax or engage in tax evasion.

It can be argued that this power structure is an unbalanced one. The government

holds all the power to tax, and the taxpayer has relatively little say in the matter.

Therefore under an argument of fairness, the onus should therefore lie with Parliament to

set clear guidelines as to when tax is exigible. The burden should be on the government

to set out under what exact circumstances tax will be due.


36

If a taxpayer doesn’t fall under these circumstances, or if it is somewhat ambiguous,

fairness dictates that any borderline situations should be resolved in favour of the

taxpayer. If Finance has a serious issue with this result, Finance has the power to amend

the provisions to eliminate the ambiguity. The taxpayer would have no such recourse.

Tax Planning is not Amoral

When discussing tax planning, it is tempting to think of tax avoidance with a

negative connotation. However, there is nothing wrong with using legal means to reduce

the amount of tax that is owed. The issue of fairness has already been discussed, but I

would add that there is nothing unfair about a taxpayer using any advantage available to

him.

Some have argued that it is unfair, and possible amoral that a large corporate

taxpayer has the resources to undertake sophisticated tax planning that, for example, an

individual taxpayer would not. However, I find it difficult to accept that a corporation

who has developed resources and perhaps expertise in the course of its business should

not be entitled to use these resources in the continued growth of its business. Why should

a successful business be forced to reduce itself to the level of its lowest competitor for the

ideal of perceived fairness? It should not. As long as the corporation came by those

advantages in a legal and lawful manner, it should be free to use them.

Furthermore, it would be naïve to think that tax considerations do not form a

major part of a business decision. Seeking to reduce taxes in a legal manner is no more

amoral than seeking to reduce risks again bankruptcy or against adverse foreign exchange


37

movements. Tax planning is an integral part of a business decision, and there is nothing

wrong in considering this.

Conclusion

With the development of the GAAR and the acceptance of a purposive approach

to statutory interpretation, it appears that economic substance is becoming relevant in

determining the taxability of a taxpayer. However, as the above analysis suggests, the

examination of economic substance is not necessarily the panacea that some make it out

to be.

Support for economic substance is grounded on the basis that it strikes at the heart

of tax planning that relies on sophisticated transactions or structures that do not reflect the

‘true’ situation. It is argued that stopping this type of tax planning is necessary as it

would otherwise result in the loss of governmental revenue, would be unfair to other

taxpayers, and would result in parliamentary congestion.

However, I would argue that these negative effects are not borne out in practice,

and should not be attributed to the taxpayer. Furthermore, the use of economic substance

analysis to eliminate these ‘evils’ may cause greater problems that would outweigh the

underlying problems that are sought to be eliminated. First, it would introduce

significant uncertainty and unpredictability for taxpayers. Second, it would place an

unfair burden on the taxpayer to stay onside of the Act. Finally, it restricts the taxpayer’s

freedom to carry out lawful tax planning.


38

Consequently, introduction of economic substance analysis into the interpretation of

taxation statutes is not recommended. However, it appears that the trend is towards a

more purposive approach to statutory interpretation, which implies an examination of

economic substance. Thus, if the introduction of economic substance must take place, it

should be done so with strict limitations.

Recommendations

In Canada Trustco, McLachlin’s approach to the GAAR indicates a reliance on

economic substance analysis. However, as we have discussed, an economic substance

analysis does have some negative aspects. Problems such as the introduction of

uncertainty and unpredictability, unfair burdens on taxpayers, and restriction of freedoms

are enough to warrant caution. Perhaps then it is possible to apply some of the principles

in Duke to guide us in shaping the economic substance examination.

Returning to the three-step the GAAR approach set out in Canada Trustco, there

are two main applications of economic substance.

Tax Avoidance

As mentioned above, an avoidance transaction is one that results in a tax benefit,

unless primarily carried out for bona fide reasons other than the reduction of tax. In order

to determine whether a taxpayer has bona fide reasons, it becomes necessary to examine

the facts and circumstances surrounding the transaction to discern the true purpose for the

transaction. This generally requires an economic substance analysis, to identify the

economic result of the transactions.


39

The problem is that this takes some of the freedom away from a taxpayer to arrange its

legal affairs in a lawful manner to reduce tax. In other words, it introduces a business

purpose test. In a situation where a taxpayer carries out transactions for the sole purpose

of reducing tax, then perhaps this is acceptable, because there is no other benefit to the

taxpayer, other than to reduce tax. However, where a taxpayer has some ‘real’

transaction, and modifies that transaction for the purpose of reducing tax, the business

purpose test can turn the transaction into an avoidance transaction. The GAAR “should

not unduly harm the level of certainty of tax treatment enjoyed by businesses that are not

engaged in avoidance.”.47

How should the competing ‘reasons’ be evaluated? Here, there is a business

purpose, and a tax-reduction purpose. If ‘primarily’ is interpreted as being more than

50%, then how does one gauge how much of the overall purpose is due to tax

motivations? This should be a concern from a policy standpoint, because now there is

uncertainty as to whether the transaction is an avoidance transaction or not. If it is found

to be an avoidance transaction, then the taxpayer is exposed to a the GAAR benefit denial

on what was initially a ‘real’ transaction.

One solution would be to remove ‘primarily’ from the legislation, or to interpret it

in such a way that requires some degree of ‘real’ purpose, but not necessarily more than

50%. This would give the taxpayer some certainty back, for as long as the taxpayer has

some non-tax purpose, the purpose requirement would be met. It would also allow for

lawful tax planning with respect to an economic transaction. At the same time, a

47

HM Revenue & Customs: A General Anti-avoidance Rule for Direct Taxes: Consultative Document, at

para. 4.1.


40

transaction carried out for only tax-motivated purposes, would still be caught under the

avoidance transaction definition.

This would also reflect some of the principles of Duke. Although there is a

business purpose test, it is not unduly onerous, since it allows full tax-planning, as long as

there is an underlying economic transaction. Thus, for the most part, a taxpayer is free to

arrange his affairs in order to reduce taxes. As mentioned above, reduction of taxes

should not be considered to be amoral, as long as lawfully carried out.

Misuse or Abuse

An avoidance transaction would be subject to benefit denial if it is reasonably

considered that the transaction would result in the misuse of the provisions of the Act, or

an abuse of the provisions as a whole.

Misuse or abuse is generally determined from an analysis of the spirit of the

provisions, and the intentions of the drafters. This is where the problems associated with

an economic substance analysis can materialize because of the inherently subjective

nature of determining intention. HM Revenue & Customs expressed concerns with such

an endeavor stating,

“There are, however, difficulties in including a reference to the evident intention

of Parliament. Indeed, one such difficulty was recognised in the TLRC's own

commentary on its illustrative provision: the purpose of introducing a GAAR is to

enable the Revenue authorities to counteract tax avoidance achieved by means of


41

complex, contrived and frequently novel transactions, which are precisely those to

which Parliament is least likely to have directed its mind.”.48

Given that most novel tax-planning ideas would not have been considered by

Parliament, reference to Parliamentary documents would not be very useful. As a result,

a great deal of uncertainty is introduced as the courts attempt to discern intention.

Safeguards should be put in place to lessen this uncertainty. One suggestion is to

require a reasonably clear intention on the part of Parliament in order to apply the misuse

or abuse provisions. This can be argued on the grounds of fairness, as the onus should be

on Parliament to clearly set out its intentions when setting taxing provisions.

Furthermore, Parliament can easily clarify its intentions from time to time, which would

not cause Parliamentary congestion, since intentions do not have to be passed into law.

Finding misuse or abuse on the part of a taxpayer, where the government has not been

clear as to their intentions is inherently unfair, since the taxpayer cannot reasonably be

expected to predict the government’s intention, and has no power to do anything once the

Parliament does express its intention. In other words, it is unfair to stack the deck in

favour of the government, when they hold all the cards.

Conclusion

Under the GAAR, economic substance analysis becomes relevant. Although this

essentially repudiates Duke, the underlying principles of Duke can provide a counter-

balance to avoid the negative consequences to an over-zealous application of economic

substance.

48

Ibid, at 6.3.3.


42

A reduction in the threshold of what constitutes a bona fide reason for the purposes of

determining whether a transaction is an avoidance transaction would be fairer to the

taxpayer, and more in line with the principles of Duke. A finding of misuse and abuse

only where there is clarity on the part of Parliament would also be fair to the taxpayer,

and would remain true to the tenets in Duke. These measures would not hinder the

government’s ability to crack down on tax avoidance, as these modifications would be of

assistance to taxpayer’s engaging in real economic transactions.

The duke is dead. It is time for the courts to accept this fact. However, if we take

the time to understand what Duke tried to teach us, we can find that Duke will live on

through its principles. Although the principles cannot be applied directly within the

legislative framework of the GAAR, the principles can provide fairness to both the

taxpayer and the revenue authorities by informing how economic substance should be

interpreted within the GAAR.


43

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44

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45

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