A Couple of More Thoughts on “Hiding in Plain Sight? Changes to “Transfer Pricing” and the GAAR"


I do not know what “good form” is for commenting on one’s own blog post.  But it does strike me that some elaboration may be helpful on the suggestion in that blog, to infuse the Canadian GAAR (and its sentiments applied in transfer pricing) with a statutory reflection of the United Kingdom GAAR’s explicit definition of “abusive” and that term’s reference to circumstances that are considered to be “abnormal” or “contrived” in relation to a taxpayer and its dealings.


Already in the GAAR?

Some might say that subsection 245(5) of the Income Tax Act, in the company of subsections 245(2) and 245(4), portends the substitution for a transaction actually undertaken by a taxpayer, for something else that supports a determination according to subsection 245(4) that the Act has been abused but was not the taxpayer’s transaction.

In some cases it may seem like this is how GAAR cases are adjudicated, and there is ample indication that this is how some of them, or their progeny, in the GAAR derivative in paragraphs 247(2)(b) and (d) of the Act are indeed formulated and argued by the Crown.  That is not, however, what that trio of provisions actually says. In combination, this is what the marriage of subsections 245(2) with the direct incorporation of some relevant definitions, says, as if they constituted a single provision:


Where a transaction, including an arrangement or event, is an avoidance transaction … [which excludes a] transaction [that] may reasonably be considered to have been undertaken or arranged primarily for bona fide purposes other than to secure the [relevant] tax benefit], … the amount of income, taxable income, or taxable income earned in Canada of, tax or other amount payable or refundable to the person under this Act, or any other amount that is relevant for the purposes of computing that amount  … to a person shall be determined as is reasonable in the circumstances in order to deny a tax benefit that … would result, directly or indirectly, from that transaction or from a series of transactions that includes that transaction … but only if it may reasonably be considered that the transaction would … result directly or indirectly in … an abuse having regard to … [(i) this Act, (ii) the Income Tax Regulations, (iii) the Income Tax Application Rules, (iv) a tax treaty, or (v) any other enactment that is relevant in computing tax or any other amount payable by or refundable to a person under this Act or in determining any other amount that is relevant for the purposes of that computation … [and to correct the abuse] (a) any deduction, exemption or exclusion in computing income, taxable income, taxable income earned in Canada or tax payable or any part thereof may be allowed or disallowed in whole or in part, (b) any such deduction, exemption or exclusion, any income, loss or other amount or part thereof may be allocated to any person, (c) the nature of any payment or other amount may be recharacterized, and (d) the tax effects that would otherwise result from the application of other provisions of this Act may be ignored in determining …  the amount of income, taxable income, or taxable income earned in Canada of, tax or other amount payable or refundable to the person under this Act, or any other amount that is relevant for the purposes of computing that amount … to a person as is reasonable in the circumstances in order to deny a tax benefit … from an avoidance transaction.


The GAAR offers statutory license to adjust amounts and even the single reference to “recharacterized” in paragraph 245(5)(c) applies to “the nature of any payment” and not the “transaction” giving rise to it.  Indeed, section 245 proceeds generally on the “transaction” undertaken by a taxpayer and not something else that may be determined or imagined to comport better with securing the Act’s objectives in relation to the circumstances and resources of a particular affected taxpayer.

It is not in the general application or tradition of our tax law, from the earliest stages of adjudication about it by the Privy Council in the Pioneer Laundry case (Judicial Committee of the Privy Council, October 13, 1939; 1 DTC 499-69 to 499-72), to “recharacterize” taxpayers’ transactions in the service of outcomes thought to be more compatible with the force and expression of the Act.  We were reminded of this most recently by both the Tax Court of Canada and the Federal Court of Appeal the Cameco Corporation cases in which it was determined that transfer pricing’s derivate of the GAAR in paragraphs 247(2)(b) and 247(2)(d) of the Act do not envisage or permit “recharacterization” but at most offers the selection of an alternative transaction as a heuristic for then applying the typical transfer pricing provisions in paragraphs 247(2)(a) and 247(2)(c).  Pointedly, the Federal Court of Appeal was highly critical of arguments by the Crown to the effect that the organizational and transactional arrangements undertaken by Cameco Corporation’s corporate group ought to be ignored because Cameco Corporation could have undertaken the same transactions itself without the intermediation of foreign affiliates.  In effect, the Court said that the mere fact that economically equivalent outcomes can be accomplished in different legally formulated ways to different tax effect is no justifiable reason to ignore or displace the taxpayer’s arrangements, provided it actually undertook them.

It may be that some GAAR decisions seem to amount to transactional substitution, but typically that approach is not one easily adopted, if at all.  More often than not, as my previous blog post discussed, GAAR analysis often seems to take on the tone and direction of a legal reference, and, at that, introspection of the Act as if only the construction of the Act mattered in determining what is abusive.  This unduly minimizes the significance of the private law to which the Act is accessory, which is effectively incorporated by reference in the Act’s relationship to; property, obligation, and transactional notions as if directly digested in the Act.

This shines a bright light on the importance of determining what is “the transaction”.  That is not a tax determination.  It is a private law determination that is relevant for interpreting and applying the Act. Possibly, then, the first step in a tax analysis is in the nature of a contract law analysis, not only where contracts are at the core of asserted tax benefits, but also as an instructive guidance about how to probe a taxpayer’s relevant conduct – to determine what is “abnormal” or “contrived” in relation to that taxpayer in relation to the rhythm and course of that taxpayer’s “life”. Hence, the possible attraction of unvarnished guidance such as that spoken in the UK GAAR, which is directional analytically and conveys a stern tone about how the tax law ought not to be manipulated in the course of events that are not genuinely transformative of a taxpayer’s condition.

None of this is to say, necessarily, that the existing GAAR (or in the relevant respect as its derivative, the tax avoidance axis of section 247 in paragraphs 247(2)(b) and 247(2)(d)) requires recalibration or refurbishment.  As I noted at the outset of the previous blog post, I do not think it does – provided however, that a suitable legal analysis is adopted to evaluate whether transactions are effective.  However, on the assumption that  a renovation is in the offing, it may be helpful to turn to the private law for inspiration about how tax-focused events that leave a taxpayer's affairs materially unchanged, but for the harvested tax benefit, might be approached as, fundamentally, inquiries into whether transactional gyrations amount to anything that should be regarded when applying the Act - whether those gyrations, no matter how thoroughly they seem to have been executed mechanically, are meant to "accomplish anything" - in other words, have "legal substance" to go with their legal "form" or configurations and in any event have fiscal significance. That evaluation is a distinctly legal evaluation, essentially to determine whether parties to a transaction, whether conceived narrowly as a contract or more broadly and inclusively as contemplated in both sections 245 and 247, intended to rely on what they portrayed in their documentation to be the transaction.  This inquiry starts some distance before the Act, before winding its way to consider the Act's application in relation to what the law will, by then, have determined "happened".


What is “the Transaction” and How is This the Essence of the GAAR?

I suggest that there is guidance to be found in what, when I entered law school almost forty-four years ago, was described to be the “modern law of contract” conceived in the scholarship on contracts and damages of Professor Lon Fuller, a very distinguished American legal scholar.

The modern law of contract, in contrast to a more doctrinaire text of the contract approach, might most readily be understood in tax terms as the difference between the “text, context and purpose” – TCP – and formalistic textual interpretations of the Act.

We can find seeds of legal sentiment underlying modern contract theory, though not in so many words, in the reasons of Justice Bowman in the Tax Court’s decision of the Continental Bank / Continental Bank Leasing cases ([1995] 1 C.T.C. 2135) which eventually made their way to the Supreme Court of Canada, entailing an examination of the legal substance of a taxpayer and its arrangements – as a legal analysis and not an untethered “substance”, economic, or reality inquiry.  I find Justice Bowman’s law-based approach to “substance” instructive; nothing is sacrificed to the fundamental inquiry about what happened, but the law is the platform on which that inquiry takes place, the source of its frame of reference.  Another example, closer to a transfer pricing home, can be found in the Supreme Court of Canada's reasons in the GlaxoSmithKline ([2012] 3 SCR 3) transfer pricing case, in which the Court noted, essentially, that contracts do not have to be written to still be legally effective contracts, and contracts as they appear may embed more specific contractual relations that ought to be regarded separately in applying the Act despite the smaller package in which a taxpayer has contained them.  That is to say, before applying the Act, the legal object of the Act's application first has to be determined - and what is seemingly apparent, cannot be taken for granted.

According to Fuller (acknowledging that this discussion telescopes a lot of scholarship into a bite size piece), a contract is not necessarily determined by how parties have described, i.e., documented, their relationship, but rather by what the evidence discloses to be the party's reasonable expectations of each other and therefore what their actual legal relations are, if found not to consistent with the expressed legal formulation.  In that event, if different, as a legal matter, the contract is what the evidence discloses it to be regardless of the ostensible projection of that relationship by documentation.

A simple example serves to make the point.  Party A engages Party B to design and build a patio in A's backyard, complete with gas lines to supply heat to the swimming pool and to fuel an elaborate outside barbeque kitchen.  Party B has no experience building patios, knows next to nothing about running gas lines, and does not have any apparent relationships with competent subcontractors.  Party B  is a "small construction shop" with no evident meaningful financial resources.  Knowing all of this but attracted by a low contract price, A engages B.  It does not go well.  A sustains losses attributable to an exploding gas line that destroys the backyard.  A has to engage another contractor, much more expensive, simply to get back to the original condition of the backyard and then to complete the project.  A sues B.  Did A sustain losses?  In the abstract, yes.  Did B "cause" the losses?  In the abstract, again, yes.  Is B responsible to A for the losses?  In the circumstances, no.  Why? Knowing what A knew, A had no reasonable expectations that B would be able to perform the contract, and objectively an awareness that harm of some kind could result from B's work.  In effect their "contract" was not what it seemed, and in determining A's damages, deserved to be overlooked.  Objectively, it tests the bounds of normality and contrivance, not because a document called a contract did not exist, but rather because it did not disclose a meaningful relationship in relation to the purpose of having contractual relations.  It wasn't a case of nefarious behavior, necessarily, but appearances were deceiving.   A sham? No - not in our sense, since there was no deceit.  An abuse?  Hard to determine.   As a reliable support for a damages claim, doubtful.

The evidence discloses what transfer pricing practitioners would refer to as the functional and financial capacity of the parties to perform their bargains.  Correspondingly, if to the awareness of one contracting party the other does not have either or both capacities to perform its side of the bargain, then the other cannot justifiably rely on that party to perform in the face of that known incapacity and accordingly seek damages for loss from the unwarranted reliance.  In other words, that party cannot reasonably insist– cannot have a reasonable expectation – that the other party it knows to be not capable or fully capable of performing its contractual relations, nevertheless should be treated as if it were capable.  That is, the apparent transaction is not the transaction that “is”, where the arrangements cannot reasonably be considered to be transformative according to their expressed terms.

This line of analysis in Fuller’s thinking , an amalgam of the law of contract and the law of damages, posits that a party claiming damages for loss of a contractual bargain should not succeed if in undertaking that bargain the party knew or reasonably ought to have known that the counterparty was unlikely to be able to perform. Not a “substance” or “economic” or “reality” analysis, but a hard-edged evidence based legal analysis. It may not be perfectly aligned with the demands of a GAAR oriented analysis, but in its attention to discovering what if anything transformative happened by examining the conditions of contract parties before, during, and after embarking on a transaction, it offers legal tools to get at what does seem to be irksome in cases justifying a look under the GAAR microscope.  It is a particularly important way of analyzing non-arm’s length relations where the formulation of arrangements as a legal matter has doubtful intrinsic significance in the circumstances because of the absence of genuinely adverse interests in commonly controlled circumstances, i.e., (“transacting with oneself).  In that event, the “transaction” as expressed by the parties effectively may be disregarded or overlooked, not for some socio-political or economic reasons, or based on general fiscal notions, but because what appears to be the contract from its formulation, is in law, taking account of a fact-based evidentiary analysis – which is a legal analysis, not the contract. So, when we refer to the UK notions of “abnormal” and “contrived” I am in part alluding to this kind of legal analysis, rather than approaches less grounded in rigorous law of the sort to which Lord Burrows referred as mentioned in the previous blog post

This kind of analysis, familiar in a private law contracts or transactions settings, can be readily accommodated by the GAAR as it is, and also the transfer pricing rules.  The kind of analysis that supports modern contract theory as espoused by Fuller offers useful directional guidance but at least an analytical metaphor in any tax analysis where the fiscal significance and efficacy of "transactions" is to be evaluated  with reference to how the Act should be applied.  But rarely, it seems, is that kind of legal analysis, which ought to ground in determinations under sections 245 and 247, undertaken directly this way.  The tendency in thinking about the GAAR is to look only inside the Act alone for inspiration and guidance about what is “abusive”.  Yet, it seems that almost irresistibly, though often surreptitiously, what is normal or genuine, in particular circumstances in relation to the behavior of a taxpayer, is what really animates a GAAR inquiry.  A good question to ask is whether direction offered by express references to “abnormal” and “contrived” would be suitable points of  statutory attitude, instruction and departure for more readily undertaking this kind of law-based legal and factual inquiry that most cases with a significant tax avoidance aspect entail, within the ambit nevertheless of still evaluating the purpose of relevant statutory provisions as they are sought to be applied.

In that regard, we might ask ourselves, "What determined the fate of the seminal Canada Trustco GAAR case?"  The answer is an evidentiary finding in the Tax Court that defeased sale and leaseback transactions were a typical form of equipment finance offered by banks, a conclusion similar to that in a like case in the UK around the same time.  And we could ask the same question about other GAAR or transfer pricing cases with equivalent to GAAR implications, like the Cameco Corporation and GlaxoSmithKline cases where fundamentally the question to be addressed (and often covertly argued) is whether fiscal regard, regard for purposes of the Act, should be had for the legal arrangements taxpayers chose to adopt.  In both cases there was evident dissatisfaction on the part of the tax authorities with the need to have engaged in more transactions than it "seemed" the commercial situations required, and therefore, that how the transactions were accomplished was "abnormal" or contrived. It would not be surprising to see this undercurrent in all the GAAR cases.

One might ask, reverting to comments earlier in this blog post and the one on which it elaborates, that if the tax law via constructive interpretations of the Act guided by "text, context, and purpose" and the implicit thinking of courts is essentially focused on what may be abnormal or contrived in the circumstances, are we not already doing what the UK GAAR offers specific statutory direction to require?  The answer may well be, yes... However, even the modest mention of recharacterization in subsection 245(5) the Act is not directing an inquiry into and a controlled disregard of  taxpayers organizational and transactional arrangements, even when it might seem that something short of a business purpose test would compel critical thinking about their fiscal significance (on the recurrence, possibly, of affirmative attention to business purpose, see this other blog post).  As noted several times, my own view is that recalibration, versus possibly more informed interpretation, is not required of either section 245 or section 247.  But there is thinking afoot which may be difficult to dispel that change is required to offer a better framework for arguments percolating already in the argument of key tax cases where perceived undue tax avoidance by name or implication is the target, even absent nefarious conduct by taxpayers.  If that is to be so, then the more modest by targeted are the changes, in keeping with what section 245 otherwise asks to be done, seem to be more likely to yield  "better outcomes".

Of course, the fact that questions about what is normal or contrived may be asked does not determine how they will be answered.  But, those notions seem to offer a home for the kind of legal analysis in the context of what the Act considers to be fiscally purposeful and therefore fiscally significant with respect to private law constructions, that lies at the heart of GAAR (and its transfer pricing cousin).


   - Professor Scott Wilkie (Distinguished Professor of Practice, Osgoode Hall Law School)