Canada: Taxpayer succeeds at overturning GAAR case on withholding tax avoidance

The Canadian Federal Court of Appeal (FCA) overturned on 17 May 2010 the Tax Court decision in Lehigh Cement Limited v. The Queen, in which the Tax Court had found that the general anti-avoidance rule (GAAR) was applicable to a financing arrangement on which the taxpayer claimed a withholding tax exemption.

Lehigh was a Canadian subsidiary of a German group and was indebted to a related Belgian treasury company. Interest on the debt was subject to a 15% withholding tax. The debt was restructured to meet the terms of a domestic withholding tax exemption that was available for interest paid to certain arm's length persons. The right to receive interest on the debt was then sold by the treasury company to an arm's length Belgian bank. The right to receive the principal was not transferred.

The Tax Court had held that the transaction was a misuse of the withholding tax exemption, finding that the purpose of the provision was to increase access to international capital markets for Canadian borrowers and the transaction allowed the withholding tax exemption to be obtained despite the fact that no funds were borrowed by Lehigh from the Belgian bank. The FCA disagreed, however, that the Crown had met the burden of proving that the exemption was misused. The only evidence of the purpose of the provision was a one-line statement in the 1975 budget papers that the provision would facilitate access to international debt markets. The FCA considered this to be a shaky foundation to determine that the exemption was not intended to be available in these circumstances. The provision is not limited on its terms to circumstances where the holder of the interest is also the holder of the principal.

The FCA noted that coupon stripping transactions (in which the right to receive interest is separated from the right to receive the principal of an obligation) are common commercial transactions and were known to the legislature when the exemption was enacted. In the FCA's view, the use of the exemption in this circumstance was not abusive merely because it may have been unforeseen or novel at the time the provision was enacted; the Crown cannot discharge its burden "merely by stating that the transaction was unforeseen or exploits a previously unnoticed legislative gap." The Crown produced no evidence that the stripping of interest from principal offended the fiscal policy objective of the withholding tax exemption.

It was noted that the Crown's argument concerning the purpose of the exemption also suffered from "irreconcilable inconsistency," since the Crown conceded that the GAAR would not apply if the principal had also been sold to the bank – yet this hypothetical alternative also would not facilitate Lehigh's access to foreign capital markets because no funds would flow to Lehigh under either alternative.

The decision is consistent with the principles laid down by the Supreme Court in the leading decision of Canada Trustco, that is, the burden is on the Crown to prove abusive tax avoidance by reference to the text, context and purpose of the provisions of the Act. If the Crown cannot meet this burden, the taxpayer is entitled to the benefit of any doubt.