In Deans Knight Income Corp. v. Canada, the Supreme Court of Canada applied the general anti-avoidance rule (“GAAR”), holding that a transaction may still be deemed abusive tax avoidance if it frustrates the rationale of the Income Tax Act.
In this decision, the defendant corporation accumulated $90 million in unclaimed non-capital losses and other tax credits. In 2007, Deans Knight Income Corp. (“Deans Knight”) tried to use its non-capital losses but did not have sufficient income to offset them. In 2008, they entered into a complex investment agreement with Matco Capital Ltd (“Matco”) to help it become profitable. The agreement was carefully drafted to ensure that Matco did not acquire control of Deans Knight by becoming the majority shareholder. This was done to prevent triggering section 111(5) of the Income Tax Act.
Under the Income Tax Act, non-capital losses are financial losses resulting from carrying on a business that spends more than it makes per year. A taxpayer may carry the loss back 3 years, or forward 20 years if they do not use all or a portion of the loss it incurred. However, section 111(5) of the Act provides that non-capital losses cannot be carried over and deducted for future taxes if the company is acquired by another entity. In this, the new owners cannot carry over unclaimed tax credits.
Deans Knight attempted to avoid this section and reduce its tax liability. When it filed its tax returns for 2009 and 2012, the company claimed nearly $65 million in non-capital losses and other tax credits. However, the Ministry of National revenue denied the deductions and the company appealed that decision to the Tax Court of Canada. It was then heard at the Federal Court of Appeal, and then at the Supreme Court of Canada.
The Supreme Court dismissed the appeal and determined that the transactions went against the rationale of section 111(5) and amounted to abusive tax avoidance. In writing for the majority, Justice Rowe held that despite complying with the literal text of a provision in the Act, a transaction is deemed abusive if it frustrates its rationale. The rationale behind section 111(5) is to prevent corporations from being acquired by unrelated parties to deduct their unused losses against income from another business for the benefit of new shareholders. While Matco did not acquire control of Deans Knight through majority voting shares, it still fundamentally changed the company’s business. This frustration of the rationale of section 111(5) was deemed to constitute abuse.
Tax law practitioners should be aware of the Supreme Court’s interpretation in this decision and remain cautious when advising clients in their application of the Income Tax Act and avoid triggering the GAAR. To read the court’s complete reasoning in Deans Knight Income Corp. v. Canada, visiting the Supreme Court website here.
