Economic Substance': Drawing the Line Between Legitimate Tax Minimization and Abusive Tax Avoidance

• Author: Jinyan Li
• Pages: 47-84

47

[two ]

“Economic Substance”:

Drawing the Line Between Legitimate Tax

Minimization and Abusive Tax Avoidance

jinyan li*

A. INTRODUCTION

Subsection () recognizes t hat the provisions of the Ac t are intended

to apply to transactions with real economic substance, not to transactions

intended to exploit, mi suse or frustrate the Ac t to avoid tax.

e GAAR draws a l ine between legitimate tax m inimization and abusive

tax avoidance. e li ne is far from bright.

While the “economic sub stance” of the trans action may be relevant at vari-

ous stages of the [sect ion ] analysis, thi s expression has little me aning in

isolation from the proper i nterpretation of specif‌ic provi sions of the Act.

* Osgoode Hall L aw School, York University, Toronto, and senior researcher at the

Policy Research I nstitute, Monash Universit y, Melbourne. is chapter was or igianlly

published in () : Ca n. Tax J. –. I thank Rick Krever, Dan iel Sandler, and the

anonymous revie wers for the Canadian Tax Journ al for their comments on the d raft of

the article. I a lso thank Chief Ju stice Donald Bowman , Al Meghji, and other part ici-

pants at the GAA R symposium for their i nsightful remark s about economic substance

in Canadia n tax law. My special than ks go to Scott Wilkie, who prov ided much inspira-

tion for this ar ticle.

Canada, Depar tment of Finance, Expl anatory Notes to Leg islation Relating to In come

Tax (Ot tawa: Department of Fi nance, ), clause  [Explanatory Notes].

e Queen v. Canad a Trustco Mortgage Co.,  SCC   at para.  [Canada Trustco].

 Ibid. at para. .

48 Jinyan Li

In enacting the gener al anti-avoidance rule (GAA R) in section  of the

Income Tax Act, Parl iament recognized, and accepted as a legiti mate part

of Canadian tax law, the well-known Duke of Westminster principle —the

taxpayer’s right to arra nge his af‌fai rs so as to attract the lea st amount of

tax; that is, to engage in tax planning.But Parliament drew a dist inc-

tion between legitim ate tax minim ization and abusive tax avoidance. e

GAAR was intended to prevent ta x planning u ndertaken solely for the

purpose of exploiting t ax law. To the extent that the GAAR applies, “the

Duke of Westminster principle and the empha sis on textual interpretation

may be atte nuated.” Ultimately, the GAAR “i s intended to strike a bal-

ance between tax payers’ need for certainty i n planning thei r af‌fairs and

the government’s responsibility to protec t the tax base and the fairne ss of

the tax system .”

In e Queen v. Canada Trustco Mortgage Co. and Mathew v. e

Queen, the Supreme Court of Canada r uled for the f‌irst time on the appli-

cation of the GAAR. e cou rt was unanimous in holdin g that the GAAR

applied in Mathew but not in Canada Trustco. e court articulated a

textual, context ual, and purposive approach to statutor y interpretation,

which should put an end to the trad itional textua l or plain meani ng ap-

proach, at least in the GAAR context . e court also set forth a number of

 RSC , c.  (th Supp.), as amended (hereafter the Ac t). Unless otherwise stat ed,

statutory reference s in this artic le are to the Act.

 Inland Revenue Commissione rs v. Westminster (Duke), [] AC  (HL).

 Canada Trustco, above note  at para. , quoting the Explanatory Notes, above note 

at clause .

 Canada Trustco, above note  at para. .

 Canada, Department of Fina nce, Tax Reform : Income Tax Reform (Ot tawa: De-

partment of Fina nce,  June ), .

 Canada Trustco,above note .

 Mathew v. e Queen,   SCC  [Mathew].

 In non-tax case s, the Supreme Court has adopted t he textual, contex tual, and purpo-

sive interpretation a s a normative statutory i nterpretation principle (see, for ex ample,

Montreal (City) v. - Québe c Inc.,  SCC , heard at about the ti me of

Canada Trustco). In tax c ases, however, the court seeme d to regard this interpre ta-

tion approach as an “extraord inary” guide t hat is not generally applicable in t he f‌irst

instance. It i s beyond the scope of this a rticle to explore the philo sophy and psychology

that may underlie th is distinction . For interesting commenta ry, see Neil Brooks, “e

Responsibilit y of Judges in Interpreting Tax Le gislation,” in Graeme S. Coope r, ed., Tax

Avoidance and the Rule o f Law (Amsterdam: IBFD P ublications, )  at –; and

Daniel M. Sch neider, “Using the Social Backgr ound Model To Explain Who Wins Fed-

eral Appellat e Tax Decisions: Do Less Tradition al Judges Favor the Taxpayer?” ()

 Va. Tax Rev. –.

“Economic Substance” 49

principles for the application of the GAA R, focusing par ticularly on sub-

section (). e key issue in these two cases wa s whether an avoidance

transaction constitutes abusive avoidance within the meaning of subsec-

tion ().

In interpreting subsec tion (), the cour t consolidated the “misuse”

and “abuse” tests into a single “abuse” t est. e court stated that a two-part

inquiry is requ ired in order to establish whether an abu se has occurred. e

f‌irst part of the inqu iry is to interpret the provi sions giving ris e to the tax

benef‌it in order to determine their obje ct, spirit, and pur pose (collectively

referred to as “legislative purpose”). is statutory interpretation issue is a

question of law, guided by the textual, contextual, and purposive interpre-

tation principle. Once the meaning a nd legislative purpose of the statutory

provisions are determined, t he second part of the inqui ry is to determine

whether the avoidance trans action falls w ithin or frus trates that purpose.

is stage involves applying the provi sions to the facts of the ca se, and is

described by the cour t as “necessarily fact-intensive.”

On the question of economic substance, referred to in the Department

of Finance explanatory notes on the GA AR (quoted above), the Supreme

Court conf‌ir med that it may be relevant at various s tages of the GAAR

analysis. However, the court made it clea r that economic substance cannot

be isolated from the fact ual context of the cas e but “must be considered

in relation to the prop er interpretation of t he specif‌ic prov isions that a re

relied upon for the tax benef‌it.”

Unfortunately, the court did not provide clea r guidelines for draw ing

the line between leg itimate tax plann ing and abusive tax avoidance. A l-

though it acknowledged t he possible relevance of economic substance , the

court did not address the followi ng key questions:

) Why should economic substance b e relevant in GAAR cases?

) What does “economic substance” mean?

) What are t he relevant factors in determin ing the economic substance of

transactions?

 Canada Trustco, above note  at pa ra. . e court reiterate d (at para. ) that, where

the two-part i nquiry is applied, t he determination of abusi ve tax avoidance “is a que s-

tion of fact” and t hen went on to state, “Provided the Tax Cou rt judge has proceeded

on a proper construct ion of the provisions of the Act a nd on f‌indings supported by t he

evidence, appellat e tribunals should not i nterfere, absent a palpable and over riding error.”

 Explanatory Notes,above not e .

 Canada Trustco, above note  at pa ra. . See also para s. –.