From sham to reality: should a wrong be taxed as a right?

• Author: Sprysak, Chris
• Position: Canada

How should a sham be treated for tax purposes? In 1524994 Ontario Ltd. v. M.N.R., the Federal Court of Appeal treated a sham as if it reflected the true agreement between the parties in order to uphold a GST assessment. The result was inconsistent with existing jurisprudence and undesirable. Courts should apply the law to the true facts only, and should not overlook or give effect to a sham in order to achieve the desired juridical consequences.

The author reviews the origins and development of the sham doctrine and introduces a three-part typology of sham cases. In situations like 1524994 Ontario Ltd. v. M.N.R., the sham is intended to obtain non-tax benefits from a third-party victim, but in the process triggers unintended tax consequences, which are the subject of litigation. Although the traditional approach in Continental Bank Leasing Corp. v. M.N.R. (under which recharacterization is permissible only if the label attached to a transaction does not reflect its actual legal effect) could result in non-payment of taxes and retention of improperly obtained benefits, the author concludes that this result would be preferable to that of the Federal Court of Appeal judgment. Treating a sham as real, and taxing a wrong as a right (1) will not deter parties from creating shams to obtain non-tax benefits, (2) will violate longstanding principles that tax law be applied with neutrality and equity and without considering its effects, and (3) will increase uncertainty and inconsistency in the case law.

Comment une operation fictive devrait-elle etre traitee aux fans de l'impot? Dans 1524994 Ontario Ltd. c. M.R.N., la Cour d'appel federale a traite une operation fictive comme refletant le vrai accord entre les parties de maniere ... leur imposer une cotisation ... la TPS. Le resultat n'etait pas conforme ... la jurisprudence actuelle et etait indesirable. Les cours devraient appliquer le droit aux faits reels et ne devraient pas ignorer ou prendre en consideration une operation fictive afin d'imposer les consequences juridiques desirees.

L'auteur passe en revue les origines et le developpement de la doctrine sur les operations fictives et introduit une typologie en trois parties des affaires traitant de l'operation fictive. Dans des cas comme 1524994 Ontario Ltd. c. M.R.N., l'operation fictive visait ... obtenir un avantage non fiscal d'une tierce partie victime, mais l'operation fictive attira des litiges fiscaux non desires. L'approche traditionnelle dans Continental Bank Leasing Corp. c. M.R.N., selon laquelle la redefinition est permise uniquement lorsque le nom attache a la transaction ne reflete pas ses effets juridiques reels, pourrait resulter en le non-paiement d'impots et en la retention de profits obtenus indument. L'auteur conclut neanmoins que ce resultat serait preferable a celui du jugement de la Cour d'appel federale. Le fait de traiter l'operation fictive comme etant reelle et de percevoir des impots comme si la transaction etait legitime (1) ne dissuadera pas les parties a s'engager dans des operations fictives afin d'obtenir des avantages non fiscaux, (2) violera les principes bien etablis voulant que le droit fiscal s'applique de facon neutre, equitable et sans egard a ses effets, et (3) creera plus d'incertitude et d'incoherence dans la jurisprudence.

Introduction I. The Sham Doctrine in Canada A. The Origins and Use of the Sham Doctrine B. The Proper Application of the Sham Doctrine: The Continental Bank Approach C. The Classification of Sham Cases II. 1524994 Ontario Ltd. v. M.N.R. A. The Facts B. The Tax Court of Canada's Findings and Decision C. The Federal Court of Appeal's Approach and Decision III. The Problems with Taxing a Sham A. The Federal Court of Appeal's Approach Will Not Discourage Parties from Creating Shams to Obtain Non-Tax Benefits B. The Federal Court of Appeal's Approach Constitutes a Biased, Results-Driven Application of Tax Law C. The Federal Court of Appeal's Approach Will Create Additional Uncertainty and Inconsistency in the Law 1. Inconsistency in What Behaviour Merits the Application of the Federal Court of Appeal's Alternate Approach 2. Inconsistency in the Legal Effect of a Sham Conclusion: A Wrong Should Not Be Taxed as a Right Introduction

How should the Canada Revenue Agency (CRA) and the courts properly treat a sham (1) for tax purposes? Should they treat it as though it reflects the actual transaction or relationship between the parties, or should they first acknowledge it as a sham and then ignore it in favour of the true facts, once ascertained? Should the proper approach be influenced by whether the sham was intended to obtain a tax or a non-tax benefit? (2) Finally, how does the proper approach in tax cases correspond to the courts' general treatment of shams where there are no tax implications or at least none being litigated?

In the recent case of 1524994 Ontario Ltd. v. M.N.R, (3) the Federal Court of Appeal had the opportunity to address these questions in deciding the appropriate goods and services tax (4) (GST) result in respect of a fraudulent agreement designed to obtain funds from the Ontario Health Insurance Plan (5) (OHIP). In my respectful opinion, the Federal Court of Appeal's decision to tax the sham as opposed to the real underlying situation, while understandable in the circumstances, was both undesirable and inconsistent with existing jurisprudence. Simply put, given the Tax Court of Canada's factual findings, the wrong should not have been taxed as a right.

This paper has two purposes. The primary purpose is to argue that regardless of the outcome, courts should apply the law only to the true facts in a case. That is, a court should hot overlook the possibility of a sham or, even worse, give it legal effect in order to achieve a result that it feels is appropriate in the circumstances, as the Federal Court of Appeal did in 1524994 Ontario Ltd. The second purpose is to use this decision as a warning to parties and their professional advisors of the dangers of inaccurately documenting their transactions and relationships. Specifically, a court may hold parties and apply the relevant law to what they have documented the facts to be, rather than to what the facts actually are.

1. The Sham Doctrine in Canada

   1. The Origins and Use of the Sham Doctrine

      At least since the Supreme Court of Canada's decision in M.N.R. v. Cameron, (6) Canadian courts have relied on Lord Diplock's definition of a sham in his decision in Snook v. London and West Riding Investments Ltd.:

      [I]t means acts done or documents executed by the parties to the "sham" which are intended by them to give to third parties or to the court the appearance of creating between the parties legal rights and obligations different from the actual legal rights and obligations (if any) which the parties intend to create.... [F]or acts or documents to be a "sham," with whatever legal consequences follow from this, all the parties thereto must have a common intention that the acts or documents are not to create the legal rights and obligations which they give the appearance of creating. (7) Three important points can be derived from this definition. First, a sham is intentional. The parties to the sham must jointly intend to create the appearance of legal rights or a relationship that differs from the actual rights or relationship. (8) Second, the essence of a sham is the attempted deception of a third party. (9) While this deception is typically designed to obtain a benefit that would not otherwise be available to the parties, shams have also been used to avoid a detriment that would otherwise result. (10) Third, while many cases that have applied the sham doctrine have been tax cases, the sham doctrine is not tax-specific. (11) Indeed, Snook was a non-tax case that concerned whether the seizure of a financed vehicle was appropriate in the circumstances. In Canada, the sham doctrine has been applied in practically all areas of the law including: corporate law, (12) pension plans, (13) receivership and bankruptcy law, (14) health law, (15) constitutional law, (16) employment insurance, (17) contract law, (18) and employment law. (19)

   2. The Proper Application of the Sham Doctrine: The Continental Bank Approach

      In Continental Bank Leasing Corp. v. M.N.R., (20) Justice Bastarache quoted the following passage from the English Court of Appeal judgment in Orion Finance Ltd. v. Crown Financial Management Ltd. as being the proper approach for identifying and handling a possible sham:

      The first task is to determine whether the documents are a sham intended to mask the true agreement between the parties. If so, the court must disregard the deceptive language by which the parties have attempted to conceal the true nature of the transaction into which they have entered and must attempt by extrinsic evidence to discover what the real transaction was....

      Once the documents are accepted as genuinely representing the transaction into which the parties have entered, its proper legal categorisation is a matter of construction of the documents. This does not mean that the terms which the parties have adopted are necessarily determinative. The substance of the parties' agreement must be round in the language they have used but the categorisation of a document is determined by the legal effect which it is intended to have, and if when properly construed the effect of the document as a whole is inconsistent with the terminology which the parties have used, then their ill-chosen language must yield to the substance. (21)

      This approach was subsequently summarized by Justice McLachlin (as she then was), writing for the Supreme Court of Canada in Shell Canada Ltd. v. Canada:

      This Court has repeatedly held that courts must be sensitive to the economic realities of a particular transaction, rather than being bound to what first appears to be its legal form. But there are at least two caveats to this rule...