Lehigh Cement Limited v. Canada (2010): The FCA Provides Guidance on Proving the “Object, Spirit or Purpose” of an ITA Provision for the Purposes of GAAR

Last month, the Federal Court of Appeal released its judgment in Lehigh Cement Limited v. Canada, 2010 FCA 124. This is the latest decision from the Court of Appeal dealing with the application of the General Anti-Avoidance Rule (“GAAR”) within the Federal Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.) (“ITA”). The appeal court was unanimous in striking down the Tax Court of Canada’s ruling in Lehigh Cement Limited v. The Queen, 2009 TCC 237, finding that the transaction at issue did not violate the GAAR.

For the unfamiliar, the GAAR is a catch-all provision within s. 245 of the ITA that serves to limit abusive tax avoidance transactions that otherwise technically comply with respective provisions of the ITA. The SCC provided the application framework for the GAAR in Canada TrustCo Mortgage Co. v. Canada, [2005] S.C.R. 601, which was followed in the case of Lipson v. R., [2009] 1 S.C.R. 3 (discussed here).

This case is notable for two reasons. One, the Canada TrustCo precedent was adhered to, with passing reference to the Lipson decision. Second, it provides guidance regarding the burden of proving that an impugned transaction is antithetical to the purpose of the ITA provision relied upon.

The Legislative Framework

Pursuant to the decision in Canada TrustCo the application of GAAR is a three step process. First, it has to be determined if a tax benefit was realized as a result of the transaction or series of transactions at issue. This consideration involves ss. 245(1) and 245(2) of the ITA. Second, the transaction or series of transactions must have been arranged primarily to realize a tax benefit. In other words, were the transactions avoidance transactions under s. 245(3)? Finally, the transaction or series of transactions must be deemed an abuse of a relied upon provision of the ITA under s. 245(4). At this step, abuse is evident if the “object, spirit or purpose” of the provision is contradicted. The taxpayer carries the burden of disproving steps one and two, and the Crown must prove step three. The taxpayer is entitled to the benefit of the doubt.

In the present case, the Tax Court and Court of Appeal were unable to agree on the “object, spirit or purpose” of subparagraph 212(1)(b)(vii). Pursuant to s. 212(1)(b) interest paid by a resident of Canada to a non-resident is taxed as income from a Canadian source. There are multiple exceptions to the application of this provision and at issue in the present case was the exemption at s. 212(1)(b)(vii). According to this subparagraph, withholding tax is not required “on interest payable by a corporation resident in Canada to a non-resident.” However, this exemption only applies if the following qualifications are met:

– interest is payable by a corporation resident in Canada;
– payable to an arm’s length non-resident person; [the “arm’s length test”] – evidence of the debt was issued by the corporation after 1975;
– the corporation is not obliged to pay more than 25% of the principal amount within 5 years from the date when the debt instrument was issued. [the “5 year test”]

The 25% rate is subject to any applicable international income tax conventions. In this case the rate was reduced to 15% pursuant to the Canada-Belgium Income Tax Convention (1976).

Background and Facts

Lehigh Cement Inc., a Canadian company, borrowed $140 million dollars from a group of Canadian banks. Lehigh was a member of a German group of corporations, the parent company being Heidelberger Zement (“HZ”). This group also included the foreign corporation CBR International Services S.A. (“International Services”), among others. Over the years the debt was sold and held by various members of the HZ group. The last member of the group to hold the debt was International Services. Pursuant to s. 212(1), as long as interest on the debt was being paid to a non-arm’s length non-resident corporation it was subject to withholding tax. To clarify, the Canadian company Lehigh, was paying interest to the foreign corporation International Services, and because both were members of the HZ group they did not deal at arm’s length. Thus, the exemption from withholding tax pursuant to s. 212(1)(b)(vii) did not apply.

Accordingly, Lehigh withheld the applicable tax for many years but eventually, as the company conceded, the debt was restructured to qualify for the s. 212(1)(b)(vii) exemption. International Services sold the right to the interest on the debt to a Belgian bank. A corporation within the HZ group received payments on the principal. Under additional terms of the restructuring, the arm’s length test and 5 year test were met. Now that Lehigh paid the interest on the debt to a non-resident corporation at arm’s length, the exemption under s. 212(1)(b)(vii) applied.

The Tax Court of Canada Rules against Lehigh

Before the Tax Court, the Crown argued that the aforementioned transaction was contrary to the GAAR because it did not meet the purpose of the ITA provision relied upon. Determining the purpose of a provision of the ITA for a GAAR analysis “should be discerned from its words, interpreted textually, contextually and purposively.” In the present case the Tax Court first referred to a paper delivered at a Canadian Tax Foundation conference in 2005 which in part read: “[t]he policy rationale behind the withholding tax exemption in subparagraph 212(1)(b)(vii) is to provide Canadian businesses with access to foreign capital markets for medium- and long-term debt.” The Tax Court also relied on additional third-party sources including an article from the Canadian Tax Journal that put forth similar rationale. It determined that this was sufficient evidence of the purpose of s. 212(1)(b)(vii).

According to the Tax Court, the purpose of s. 212(1)(b)(vii) is “to help Canadian corporations needing to borrow money by increasing their access to international capital markets. The exemption from withholding tax on arm’s length borrowing from foreign lenders makes such borrowing more competitive with domestic borrowing in Canada.” Furthermore, “the tax benefit applies only to the arm’s length borrowing of capital from a non-resident lender…” A transaction under s. 212(1)(b)(vii) has to be with a “certain commercial purpose…[Lehigh] did not borrow any money from [the Belgian Bank] or any other non-resident lender.” It merely sold the right to the interest to a foreign corporation at arm’s length. Hence, the provision was abused and both the avoidance transaction and resulting tax benefit were disallowed.

The Crown Fails to Meet its Burden

The main issue before the Federal Court of Appeal was the “object, spirit or purpose” of subparagraph 212(1)(b)(vii).The appeal court decided that the Crown did not meet its burden of proving the purpose of s. 212(1)(b)(vii).

Lehigh argued that it simply took advantage of the available exemption. All that was required was that the two tests under the provision (the 5 year test and arm’s length test) be met. According to Lehigh, the transaction did not violate the purpose of the two tests:

The 5 year test is intended to ensure that the debt is medium to long term debt…The arm’s length test is intended to ensure that the contractual conditions governing the debt, particularly the interest rate, fairly reflect the applicable market.

Of course, the preceding argument did not take into account the textual, contextual and purposive analysis mandated by the CanadaTrustCo decision regarding the application of the GAAR. The GAAR comes into play precisely when the statutory requirements are met but it is alleged that the provisions have been abused in order to realize a tax benefit.

The interest payments were to a foreign company at arm’s length. According to the Appeal court, the arm’s length test only had “to be met in respect of the relationship between the person required to pay the interest and the person entitled to be paid the interest.” Furthermore, the splitting of the interest from the principal was acceptable and common in commercial financing transactions. Finally, s. 212(1)(b)(vii) “is broad enough to include any interest payable by a corporation resident in Canada to a non-resident, no matter how the non-resident may have become entitled to receive that interest.”

The Appeal court ruled that the Crown did not meet its burden of proving the “object, spirit or purpose” of s. 212(1)(b)(vii). As a result, the Crown was not able to establish that the purpose had been defeated. If the Appeal court had agreed with the Tax Court’s determination of the purpose of s. 212(1)(b)(vii) surely that decision would have been upheld—Lehigh did not borrow from the Belgian bank, the loan interest and principal were split, and the right to the interest was sold to an arm’s length foreign entity. While technically legitimate, this was not within the purpose of s. 212(1)(b)(vii) as stated by the Tax Court.

The Crown’s “Shaky Foundation”

This decision suggests that when establishing the purpose of a provision of the ITA the burden on the Crown is relatively stringent. While the Tax Court accepted a single Parliamentary document and related journal and conference articles, the Court of Appeal decided that those documents did not sufficiently evidence the purpose of s. 212(1)(b)(vii).

Importantly, there was no case law presented to support the Crown’s position and nor was there mention of a Parliamentary record indicating the purpose of s. 212(1)(b)(vii), except for one Department of Finance publication from 1975. The publication in part stated: “[t]he proposed relief from withholding tax is intended to increase the flexibility of Canadian business to plan long-term debt financing and facilitate access to funds in international capital markets.” The Appeal court conceded that the “1975 budget paper says something about the history of subparagraph 212(10(b)(vii)” but ultimately that was not enough:

[I]t is fatal to the Crown’s misuse argument that it finds no support in any provision of the Income Tax Act, or in any jurisprudence or other authority saying or suggesting that the splitting of the interest and principal obligations of a debt have any income tax implications in relation to subparagraph 212(1)(b)(vii), or any analogous provision or relevant statutory scheme.

It may be comforting to some tax counsel to know that the burden of proving misuse or abuse under s. 245(4) remains relatively high. In the Lipson decisions, the SCC, the Federal Court of Appeal, and the Tax Court of Canada all referenced case law indicating the purpose of the provisions at issue. In the present case the Crown did not advance any case law to support its determination and the evidence it did present was inadequate. Ultimately, it appears that if a reassessment under GAAR is to be successful the Crown must provide evidence of the purpose of a provision of the ITA through supporting case law or a substantive Parliamentary record.