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Economic Substance and GAAR:
A Critical and Comparative Perspective
Jinyan Li
Osgoode Hall Law School
Outline
1. Is “Economic Substance” relevant to GAAR?
2. What does “economic substance” mean?
3. What is the proper role of “economic
substance” under s.245(4)?
4. How to determine “economic substance”?
5. What are the implications of Canada Trustco
and Kaulius
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1-a Relevance of “Economic
Substance”
• “Subsection 245(4) recognizes that the
provisions of the Act are intended to
apply to transactions with real
economic substance, not to
transactions intended to exploit, misuse
or frustrate the Act to avoid tax.”
- Explanatory Notes (quoted by SCC)
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1-b Relevance of “Economic
Substance” - SCC
• SCC - Canada Trustco
• “may be relevant at various stages of the analysis”
• but “has little meaning in isolation from the proper
interpretation of specific provisions of the Act”
• Did not analyze “economic substance”
• CCA rules did not require economic substance
• “Cost” means “legal” cost, not “economically at risk
amount”
SCC’s interpretation of “economic substance” too narrow
•
Similar reasoning in Barclays Mercantile (although no GAAR in UK)
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1-c Relevance of “Economic
Substance” - SCC
• SCC – Kaulius
• “Economic substance” not mentioned
in the decision
• Implicitly important in interpreting
legislative purpose
• Considered some factors that are used
in determining “economic substance” in
other countries
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2.
What Does “Economic
Substance” Mean?
• No definition by SCC,
• “may be open to different interpretations”
• “Real” economic substance: “Characterize
transactions or arrangements in accordance
with their economic substance or realities.”
(Gregory v. Helvering, Long Term Capital, Frank Lyon)
• “Substance over form”/”legal substance”
(Continental Bank, Shell, Duke of Westminster)
• “business purpose + step transactions”
(“composite transaction”) (Ramsay, Furniss v. Dawson)
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2-a Origin of the Doctrine
• Gregory v. Helvering (1934) (Learned Hand J.)
• Source of “first principles” on the economic substance
doctrine
• All the steps were real and their only defect was that
they were not what the statute means by a
“reorganisation”
• business context/purpose was required
• Mrs. Gregory’s transactions
– Did not change Ms. Gregory’s economic position,
apart from the tax benefit,
– Did not reflect any facet of Aco’s business.
i.e., the transactions lacked economic substance.
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3.
Proper Role of “Economic
Substance” under s.245(4)
• Crucial role
• Text: “result” of the transaction (legal,
financial, commercial, and economic
results)
• Context: Historical; No
recharacterization outside s.245(4), if
no recharacterize under s.245(4),
GAAR would be meaningless
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3-a Proper Role of “Economic
Substance” under s.245(4)
• Purpose of s.245(4)
– provisions of the Act are intended to apply
to transactions with real economic
substance (Exp. Notes)
– GAAR is intended to apply where under a
literal interpretation of the provisions of the
Act, the object and purpose of those
provisions would be defeated (SCC)
– Distinguish between legitimate tax
minimization and abusive tax avoidance
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3-b Economic Substance under
s.245(4)
Should be relevant in the 2-part inquiry under
s.245(2)
General approach:
A transaction lacking real economic
substance presumably frustrates legislative
purpose, unless it is clearly supported by the
text, intent, and purpose of the provisions of
the Act read as a whole
Otherwise, asymmetrical movement:
 purposive construction of statute
 Formalistic construction of facts
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4.
How to Determine
“Economic Substance”?
• SCC provided some guidance
• Canada Trustco:
– “Cost = at risk amount” is “narrow” view of
economic substance
– Transaction similar to “ordinary sale-leaseback”
• Kaulius
– the losses originated from another taxpayer
– Partnership A was “holding vehicle” for the
unrealized losses;
– Partnership B’s sole purpose was to realize and
allocate the tax losses
– the amount of tax loss claimed
• International experience
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4-a Determination of Economic
Substance
How many Nobel Prize-winning
economists does it take to determine
whether a transaction has “economic
substance”??
Myron Scholes, Robert Merton
Joseph Stiglitz
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4-b Long Term Capital Holdings (2004)
• Similar to Kaulius
• Designed by Myron S. Scholes (winner of a Nobel in
economics)
• 1996 OTC transferred preferred stock (basis of
$107m) to LTCP in exchange for a partnership
interest in LTCP.
• LTCP in turn contributed the preferred stock to a
lower-tier partnership called Portfolio (tax-free
transactions)
• 1997, Portfolio sold stock to investment bank for
$1m, realized loss of $106m
• Portfolio allocated the capital loss to LTCP, which
then allocated the capital loss in received to LTCM.
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4-c Long Term Capital Holdings
• Held:
– Transaction lacks economic substance and
is ignored for tax purposes
• Objective test:
• Cost/benefit analysis,
– using above-market rate of return (known for the
hedge fund)
– compared the potential profit to the sizeable
amounts paid as attorney fees, consultant fees,
bonuses
• no prudent investor would knowingly and
intentionally incur costs above a reasonable
gain
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4-d Long Term Capital Holding
• Subject test (business purpose)
• Not reasonable to conclude primary
motivation is to earn management fees
• Level of sophistication possessed by Long
Term’s principals in matters economic
• Mr. Scholes’ concession that the deal was
viewed by his partners as a tax deal
• the construction of an elaborate, time
consuming, inefficient and expensive
transactions with OTC for the purported
purpose of generating fees itself points to
Long Term’s true motivation, tax avoidance.
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4-e Frank Lyon (US)(1978)
•
•
Sale-leaseback transaction
–
rent equal to the taxpayer's payments of principal
and interest on the loan borrowed to finance the
acquisition
–
Lessee bank could not own the building because
of bank regulations
US SC upheld the transaction:
–
“genuine multiple-party transaction” compelled by
business or regulatory realities”
–
transaction “imbued with tax-independent
considerations”;
–
transaction “was not shaped solely by tax
avoidance features that have meaningless labels
attached”
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4-f Australian GAAR
• Avoidance transaction subject to GAAR
• Objective factors (s.177D of ITAA)
– commercial reality and legal substance of
the scheme
– Results that would have been achieved by
the scheme if GAAR did not apply
– Change in financial position of the taxpayer
(Inferences adverse to a taxpayer may be
drawn if the scheme provides a tax benefit
without any significant financial detriment)
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Proposed GAAR in South Afirca
• Form and economic substance of the
arrangement
• Circular flow of cash or assets
• Lack of any change in the financial position
• Absence of a reasonable expectation of pretax profit
• Value of tax benefit exceeds amount of pretax profit reasonably expected in connection
with that arrangement.
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5. Implications of SCC Rulings
• “Economic substance” relevant to
GAAR, but no clear guidelines
• Clarification needed
• Legitimate tax planning not affected by
“economic substance” analysis
• “Burden of proof”?
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