Issue 2023-37

In brief

On November 30, 2023, the federal government tabled Bill C-59,¹ which includes legislation that amends the general anti-avoidance rule (GAAR) in section 245 of the Income Tax Act (the Act). The amendments are intended to strengthen the GAAR by:

• introducing a preamble to guide the interpretation of the GAAR, effective upon royal assent of Bill C-59 
• for transactions that occur after 2023:
  • lowering the “avoidance transaction” standard
  • introducing an economic substance rule 
  • applying a three-year extension of the normal reassessment period
• implementing a penalty, effective for transactions that occur on or after the later of January 1, 2024 and the day on which Bill C-59 receives royal assent

This Tax Insights provides an overview of these legislative changes. Taxpayers should consider reviewing and learning about these changes and determine if they could apply to their existing or contemplated transactions.

In detail

Background

The GAAR is intended to prevent abusive tax avoidance transactions while not interfering with legitimate commercial or family transactions. If abusive tax avoidance is established, the GAAR applies to deny the tax benefit created by the abusive transaction or series of transactions. The Canada Revenue Agency (CRA) may deny any deduction, exemption or exclusion in computing taxable income, or may recharacterize the nature of any payment or other amount to deny the tax benefit that would result from an avoidance transaction.

On August 9, 2022, the federal government launched a consultation on modernizing the GAAR and, in its 2023 federal budget, announced specific proposals to amend the GAAR, which were subject to further consultation. The legislation in Bill C-59 implements the changes that were discussed in and shaped by these consultations.

Preamble

Bill C-59 introduces a preamble to the GAAR, which is intended to:

• inform the application of the GAAR, despite not forming a part of its analytic framework 
• help address interpretive issues and ensure that the GAAR applies as intended
• reinforce that the GAAR is a provision in the Act and is an important part of ensuring that the Act meets its objectives 

The preamble provides that the GAAR “applies to deny the tax benefit of avoidance transactions that result directly or indirectly either in a misuse of provisions of the Act ... or an abuse having regard to those provisions read as a whole, while not preventing taxpayers from obtaining tax benefits contemplated by Parliament.” This shows that the GAAR is intended to serve as a limit on tax planning, providing that the taxpayer’s freedom to engage in certain forms of tax planning does not extend to misusing or abusing the tax rules.

The preamble clarifies that the GAAR seeks to establish a reasonable balance between the protection of the tax base and the need for certainty for taxpayers in planning their affairs.

Avoidance transaction 

The GAAR only applies to “avoidance transactions.” Bill C-59 amends the avoidance transaction test by lowering the threshold under the purpose test. The “primary purpose” test in the current avoidance transaction test will change to a “one of the main purposes” test, which lowers the threshold for a transaction to be considered an avoidance transaction. More specifically, a transaction will be an avoidance transaction if one of the taxpayer’s main purposes for undertaking or arranging the transaction was to obtain a tax benefit. 

Economic substance

Bill C-59 introduces an explicit economic substance test into the GAAR, which will be considered at the “misuse or abuse” stage of the analysis under subsections 245(2) and (4) of the Act. This is intended to ensure that economic substance receives proper consideration when assessing whether an avoidance transaction frustrates the object and purpose of the relevant provisions.

New subsection 245(4.1) of the Act provides that “[i]f an avoidance transaction ... is significantly lacking in economic substance, this is an important consideration that tends to indicate that the transaction results in a misuse under paragraph 4(a) or an abuse under paragraph (4)(b).” As such, a significant lack of economic substance is to be taken into account as an important factor that weighs in favour of finding that there has been a misuse or abuse. 

Accordingly, a significant lack of economic substance may indicate that there is a misuse or abuse. However, depending on the relevant facts and law, other considerations may demonstrate that the transaction does not frustrate the rationale of the provisions and thus does not result in a misuse or abuse. 

The meaning of the phrase “significantly lacking in economic substance” is provided in new subsection 245(4.2); it lists the following factors which may establish that a transaction is significantly lacking in economic substance (this is not an exhaustive list of factors):

• all or substantially all of the opportunity for gain or profit and the risk of loss remains unchanged because of:
  • a circular flow of funds
  • offsetting financial positions
  • the timing between steps in a series, or
  • the use of an accommodation party
• it is reasonable to conclude that:
  • the expected value of the tax benefit exceeds the expected non-tax economic return 
  • the entire (or almost entire) purpose for undertaking the transaction was to obtain the tax benefit

Penalty

Bill C-59 introduces a penalty equal to 25% of the tax benefit obtained when the GAAR is found to apply. Where the tax benefit obtained is the creation of a tax attribute that has not yet been used to reduce tax payable, no penalty will apply until the year in which the tax attribute is applied to reduce tax payable.

The penalty can be avoided if: 

• the transaction is disclosed to the CRA, either voluntarily or under the mandatory disclosure rules,² or
• the exclusion to the GAAR penalty applies   

The exclusion to the GAAR penalty provides that the penalty will not apply in respect of a transaction if the taxpayer demonstrates that it was reasonable to conclude that a transaction or series would not be subject to the GAAR at the time it was entered into. The taxpayer must demonstrate that the transaction or series was identical or almost identical to a transaction or series that was the subject of published administrative guidance or a court decision, such that it was reasonable to have concluded that the GAAR would not apply.

The “identical or almost identical” threshold is high and entering into a transaction that is merely similar may not be enough to qualify for this exclusion to the GAAR penalty.

Extended period of assessment

The “normal reassessment period” for a taxpayer in respect of a taxation year is generally the period that ends three or four years (the latter if the taxpayer is a mutual fund trust or a corporation other than a Canadian-controlled private corporation) after the earlier of the mailing date of: 

• a notice of an original assessment
• an original notification that no tax is payable by the taxpayer for the year

The CRA generally may not assess or reassess after the “normal reassessment period” for the year. 

Bill C-59 introduces legislation that allows the CRA to extend the reassessment period by three years for transactions or series of transactions that have been assessed as a result of the application of the GAAR, unless the transactions have been disclosed to the CRA, either voluntarily or under the mandatory disclosure rules. In this regard, any reassessment within this additional three-year period will be limited to the assessment of the GAAR.

The takeaway

Except for the preamble, which comes into force on royal assent of Bill C-59, the amendments to the GAAR will apply to transactions that occur after 2023. It is difficult to determine at this early stage how these amendments could impact the determination of whether the GAAR applies to certain transactions; it could increase the risk of implementing them, including penalties of up to 25% of the tax benefit.

^{1. Bill C-59, An Act to implement certain provisions of the fall economic statement tabled in Parliament on November 21, 2023 and certain provisions of the budget tabled in Parliament on March 28, 2023 (first reading: November 30, 2023)}

<sup>2. For more information, see our Tax Insights:
- "Mandatory disclosure rules: Taxpayers, advisers and promoters need to prepare"
- "Canada Revenue Agency officially designates first notifiable transactions"</sup>