On November 24, 2017, the Tax Court of Canada rendered its judgment in Birchcliff Energy Ltd. v. The Queen (TCC), 2017 TCC 234 ("Birchcliff"), holding that the GAAR was applicable to a series of transactions in which Birchcliff amalgamated with an unrelated company that had accumulated $16 million in losses. The judgment supersedes the decision in 2015 TCC 232, following the Federal Court of Appeal’s referring the matter back to the Tax Court (2017 FCA 89). This week's post summarizes Birchcliff and draws insights from Tax Foresight's GAAR Case Finder.
The Provisions at Issue: Sections 111 and 256 of the Income Tax Act
Paragraph 111(1)(a) permits the carryback or carryforward of unused business losses (non-capital losses) over a period of time. Subsection 111(5) limits the ability to do so where a corporation has undergone a change of control.
Paragraph 256(7)(b) sets out deeming rules regarding what constitutes a change of control in the context of the amalgamation of corporations. Generally, when two unrelated companies amalgamate, the effect of paragraph 256(7)(b) is to deem one of the two predecessor corporations to have acquired control of the other immediately before the amalgamation. However, clause 256(7)(b)(iii)(B) provides an exception (the "Exception") if the shareholders of each predecessor end up with an equal number of votes in the amalgamated corporation.
The court in Birchcliff concisely explains the general rule and the Exception using a hypothetical scenario that assumes that each predecessor corporation has a single shareholder. If the hypothetical shareholder of a particular predecessor has control of the amalgamated company, that predecessor is deemed to have acquired control of the other predecessor just before the amalgamation. If neither of the two hypothetical shareholders has control of the amalgamated corporation, there is no deemed change of control of either predecessor. The court stated at para. 23: "One might think about this as a rule about which predecessor company, if any, took control of the amalgamated company."
The Transactions in Birchcliff
The amalgamating companies were Veracel Inc. (“Veracel”) and Birchcliff Energy Ltd. (“Birchcliff”). Veracel operated as a medical diagnostics company from 1994 to 2002, when it filed for bankruptcy and ceased business. In that time, Veracel had accumulated approximately $16 million in non-capital losses (the “Veracel Losses”). Birchcliff was in the oil and gas business. In 2005, Veracel and Birchcliff amalgamated under the name Birchcliff. The steps leading to the amalgamation included the creation of Class B shares of Veracel immediately prior to the amalgamation, which satisfied the text of the Exception. According to the letter of paragraph 256(7)(b), there was no deemed change of control and the amalgamated Birchcliff (“Amalco”) claimed the Veracel Losses in filing its 2006 tax return.
The Primary Issue: GAAR
The Minister made three alternative arguments to deny Amalco’s deduction of the Veracel Losses:
- The Class B shares were a sham and should be disregarded in applying the test for the Exception.
- The Class B shareholders acquired control of Veracel immediately before the amalgamation.
- The transactions were abusive of the rules in subsection 256(7) and the GAAR should be applied.
Our analysis in this newsletter focuses on issue 3. The Tax Court did not accept argument 1 or 2.
The court found that Amalco’s use of the Veracel Losses clearly constituted a tax benefit. The series of transactions leading up to the amalgamation constituted an avoidance transaction because it served no purpose other than to obtain the tax benefit. At para. 123, Justice Jorré found that, “Veracel wanted to monetize its tax attributes; Birchcliff wanted to obtain those tax attributes. All the rest was done to accomplish those objectives.”
The bulk of the court’s analysis focused on the question of whether the avoidance transaction was abusive. After examining the text and context of subsection 256(7), Justice Jorré concluded that the policy underlying the provision is that the “minority” predecessor will lose its tax attributes (including losses) upon amalgamating with another corporation.
Justice Jorré concluded that the artificial insertion of Class B shareholders of Veracel frustrated the object of the rule in 256(7) because it manipulated the shareholdings of a predecessor corporation. The court stated at para. 137:
Put another way, it would be contrary to the policy of the provision to take account of the Class B shares where the existence of the shares is an ephemeral one at the time of the amalgamation and where the very existence of those shares is predicated on the amalgamation itself occurring. It is only at that instant, the instant where various events are deemed to occur in a sequence, that the new Class B shareholders contribute to the capital stock of the corporation.
Insights from Tax Foresight’s GAAR Case Finder:
- The GAAR has been applied in over 60% of rulings categorized as loss transfer or synthetic loss cases.
- Birchcliff is the only case in which the Minister alleged an abuse of section 256.
- Six GAAR cases have been decided since January 1, 2017. The GAAR was applied in four and not applied in two.
- Birchcliff is the second GAAR decision authored by Justice Jorré. GAAR was applied in the first as well: Gervais v. The Queen, 2016 TCC 180.
Read Tax Foresight’s GAAR Primer for additional insights on all 100 GAAR cases.