Economic Substance and GAAR:A Critical and Comparative Perspective

Jinyan Li

Osgoode Hall Law School

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Outline

1. Is “Economic Substance” relevant to GAAR?

2. What does “economic substance” mean?

3. What is the proper role of “economic substance” under s.245(4)?

4. How to determine “economic substance”?

5. What are the implications of Canada Trustco and Kaulius

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1-a Relevance of “Economic Substance”

• “Subsection 245(4) recognizes that the provisions of the Act are intended to apply to transactions with real economic substance, not to transactions intended to exploit, misuse or frustrate the Act to avoid tax.”

- Explanatory Notes (quoted by SCC)

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1-b Relevance of “Economic Substance” - SCC• SCC - Canada Trustco• “may be relevant at various stages of the analysis”• but “has little meaning in isolation from the proper

interpretation of specific provisions of the Act”• Did not analyze “economic substance”• CCA rules did not require economic substance• “Cost” means “legal” cost, not “economically at risk

amount”

SCC’s interpretation of “economic substance” too narrow• Similar reasoning in Barclays Mercantile (although no GAAR in UK)

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1-c Relevance of “Economic Substance” - SCC

• SCC – Kaulius• “Economic substance” not mentioned in

the decision• Implicitly important in interpreting

legislative purpose • Considered some factors that are used

in determining “economic substance” in other countries

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2. What Does “Economic Substance” Mean?

• No definition by SCC, • “may be open to different interpretations”• “Real” economic substance: “Characterize

transactions or arrangements in accordance with their economic substance or realities.”

(Gregory v. Helvering, Long Term Capital, Frank Lyon)• “Substance over form”/”legal substance”

(Continental Bank, Shell, Duke of Westminster)• “business purpose + step transactions”

(“composite transaction”) (Ramsay, Furniss v. Dawson)

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2-a Origin of the Doctrine

• Gregory v. Helvering (1934) (Learned Hand J.)• Source of “first principles” on the economic substance

doctrine • All the steps were real and their only defect was that

they were not what the statute means by a “reorganisation”

• business context/purpose was required• Mrs. Gregory’s transactions

– Did not change Ms. Gregory’s economic position, apart from the tax benefit,

– Did not reflect any facet of Aco’s business. i.e., the transactions lacked economic substance.

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3. Proper Role of “Economic Substance” under s.245(4)

• Crucial role• Text: “result” of the transaction (legal,

financial, commercial, and economic results)

• Context: Historical; No recharacterization outside s.245(4), if no recharacterize under s.245(4), GAAR would be meaningless

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3-a Proper Role of “Economic Substance” under s.245(4) • Purpose of s.245(4)

– provisions of the Act are intended to apply to transactions with real economic substance (Exp. Notes)

– GAAR is intended to apply where under a literal interpretation of the provisions of the Act, the object and purpose of those provisions would be defeated (SCC)

– Distinguish between legitimate tax minimization and abusive tax avoidance

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3-b Economic Substance under s.245(4)

Should be relevant in the 2-part inquiry under s.245(2)

General approach:A transaction lacking real economic substance presumably frustrates legislative purpose, unless it is clearly supported by the text, intent, and purpose of the provisions of the Act read as a whole

Otherwise, asymmetrical movement: purposive construction of statute Formalistic construction of facts

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4. How to Determine “Economic Substance”?• SCC provided some guidance• Canada Trustco:

– “Cost = at risk amount” is “narrow” view of economic substance

– Transaction similar to “ordinary sale-leaseback”• Kaulius

– the losses originated from another taxpayer – Partnership A was “holding vehicle” for the

unrealized losses; – Partnership B’s sole purpose was to realize and

allocate the tax losses– the amount of tax loss claimed

• International experience

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4-a Determination of Economic Substance

How many Nobel Prize-winning economists does it take to determine whether a transaction has “economic substance”??

Myron Scholes, Robert Merton

Joseph Stiglitz

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4-b Long Term Capital Holdings (2004)

• Similar to Kaulius• Designed by Myron S. Scholes (winner of a Nobel in

economics) • 1996 OTC transferred preferred stock (basis of

$107m) to LTCP in exchange for a partnership interest in LTCP.

• LTCP in turn contributed the preferred stock to a lower-tier partnership called Portfolio (tax-free transactions)

• 1997, Portfolio sold stock to investment bank for $1m, realized loss of $106m

• Portfolio allocated the capital loss to LTCP, which then allocated the capital loss in received to LTCM.

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4-c Long Term Capital Holdings • Held:

– Transaction lacks economic substance and is ignored for tax purposes

• Objective test:• Cost/benefit analysis,

– using above-market rate of return (known for the hedge fund)

– compared the potential profit to the sizeable amounts paid as attorney fees, consultant fees, bonuses

• no prudent investor would knowingly and intentionally incur costs above a reasonable gain

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4-d Long Term Capital Holding

• Subject test (business purpose)• Not reasonable to conclude primary

motivation is to earn management fees • Level of sophistication possessed by Long

Term’s principals in matters economic• Mr. Scholes’ concession that the deal was

viewed by his partners as a tax deal • the construction of an elaborate, time

consuming, inefficient and expensive transactions with OTC for the purported purpose of generating fees itself points to Long Term’s true motivation, tax avoidance.

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4-e Frank Lyon (US)(1978)

• Sale-leaseback transaction – rent equal to the taxpayer's payments of

principal and interest on the loan borrowed to finance the acquisition

– Lessee bank could not own the building because of bank regulations

• US SC upheld the transaction:– “genuine multiple-party transaction”

compelled by business or regulatory realities”

– transaction “imbued with tax-independent considerations”;

– transaction “was not shaped solely by tax avoidance features that have meaningless labels attached”

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4-f Australian GAAR

• Avoidance transaction subject to GAAR• Objective factors (s.177D of ITAA)

– commercial reality and legal substance of the scheme

– Results that would have been achieved by the scheme if GAAR did not apply

– Change in financial position of the taxpayer (Inferences adverse to a taxpayer may be drawn if the scheme provides a tax benefit without any significant financial detriment)

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Proposed GAAR in South Afirca

• Form and economic substance of the arrangement

• Circular flow of cash or assets • Lack of any change in the financial position • Absence of a reasonable expectation of pre-

tax profit • Value of tax benefit exceeds amount of pre-

tax profit reasonably expected in connection with that arrangement.

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5. Implications of SCC Rulings

• “Economic substance” relevant to GAAR, but no clear guidelines

• Clarification needed• Legitimate tax planning not affected by

“economic substance” analysis• “Burden of proof”?