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Deans Knight Income Corporation v. His Majesty the King, 2023 SCC 16

Desautels Blog Case Reporter

Written by Cole Milberg

Introduction

Deans Knight Income Corporation v. His Majesty the King, 2023 SCC 16 (“Deans Knight”) reinforces the Supreme Court of Canada’s (“SCC”) approach to the general anti avoidance rule (“GAAR”). Deans Knight reiterates the court’s reasoning that even while a tax avoidance strategy abides by the strict language of the Income Tax Act (“ITA”), when such strategies are deemed to be a “functional equivalent” of an action disallowed under the ITA, there will be a significant likelihood of GAAR being applicable. This case report summarizes the key reasoning behind the court’s decision and describes its impacts.

Brief Background

  • Section 111(1)(a) of the Income Tax Act allows a taxpayer’s non‑capital losses to be carried back or forward to different taxation years to offset income in those years.[1]
  • Section 111(5) restricts non‑capital loss carryovers for a corporation if a person or group of persons has acquired control of the corporation unless it continues the same or similar business that incurred the losses.[2]
  • The object, spirit, and purpose of section 111(5) is to prevent corporations from being acquired by unrelated parties to deduct their unused losses against income from another business to benefit new shareholders.[3]

In Deans Knight, Deans Knight, a public corporation, had accumulated 90 million dollars in business losses and did not predict an availability of future profits to utilize these losses in subsequent years.[4] In an attempt to monetize these losses while avoiding a change in de jure control (which would trigger section 111(5) of the ITA), Deans Knight engaged in several transactions with an arm’s length corporation, Matco. These transactions, in the view of the court, while not resulting in a change in de jure control as defined narrowly, amounted to a “functionally equivalent”[5] transaction that frustrated the object, spirit, and purpose of s 111(5)[6] and thus was found to violate section 111(5) in accordance with the general anti-avoidance rule (“GAAR”).[7]

“Control,” as referenced in section 111(5), has been determined by the SCC to be de jure control, meaning the ownership or control over the voting rights of such a number of the corporation’s shares that would entitle one to elect a majority of the corporation’s board of directors.[8] The transactions completed by Deans Knight included reorganizing under a subsidiary, NewCo, which negotiated an agreement with Matco. This agreement entailed Deans Knight issuing a debenture to Matco convertible for 35 percent of its voting and 79 percent of its non-voting shares in exchange for 3 million dollars (which were subsequently transferred to NewCo).[9] Moreover, under the agreement, Matco identified an income-generating business for Deans Knight which was used to launch an initial public offering (“IPO”), the shares of which were sold to Matco for $800,000 and offset using Deans Knight’s business losses.[10]

As a result of these transactions, Deans Knight was able to monetize its business losses without triggering an “acquisition of control,” thus not triggering section 111(5) on face value. However, as a result of the agreement, Matco gained the power of a majority voting shareholder, was granted contractual rights to oversee the makeup of the board of directors,[11] was granted contractual veto powers, which prohibited Deans Knight from taking a variety of actions,[12]and Matco fundamentally changed Deans Knight’s assets, liabilities, shareholders and business.[13] This series of transactions, in the view of the court, amounted to a “functional equivalent” to de jure control,[14] making the transaction in conflict with section 111(5).

Decision

The court employed a GAAR analysis, asking whether in conducting this transaction (1) there was a tax benefit, (2) the transaction giving rise to the tax benefit was an avoidance transaction, and (3) the avoidance transaction was abusive.[15] As the transactions employed by Deans Knight and Matco were an avoidance transaction that yielded a tax benefit which frustrated the object, spirit and purpose of section 111(5), (the purpose being to prevent corporations from being acquired by unrelated parties to deduct their unused losses against income from another business for the benefit of new shareholders),[16] it was determined to be an abusive transaction.[17]

Conclusion

While Deans Knight makes no significant changes to the jurisprudence surrounding GAAR, it reinforces the principle that while some tax avoidance strategies may abide by the literal text of the ITA, they can still be found to be in contravention of GAAR due to non-compliance with the object, spirit, and purpose of the provisions within the statute. To stay compliant, taxpayers must be cautious to not rely too heavily on the text of the relevant statutes and must be cognizant to avoid employing “functional equivalents” of actions disallowed by the ITA. 

More reasons to be cognisant of GAAR include the associated penalties. For taxpayers who fail to abide by these principles, the infringing tax benefits will be removed,[18] forcing the taxpayer to pay the tax previously avoided via use of the avoidance mechanism. Moreover, taxpayers will be levied a penalty for engaging in a tax avoidance transaction that equals 25% of the disallowed tax benefit, in accordance with new changes implemented via Bill C-59.[19] To note, the 25% penalty would not apply to transactions disclosed to the Canada Revenue Agency (CRA) under the new mandatory disclosure rules.[20]

[1] Deans Knight Income Corporation v. His Majesty the King, 2023 SCC 16 at para 2. [“Deans Knight”].

[2] Ibid.

[3] Ibid at para 6.

[4] Ibid at para 7.

[5] Ibid at para 128.

[6] Ibid at para 122.

[7] Ibid at para 7.

[8] Ibid at para 2.

[9] Ibid at para 11.

[10] Ibid.

[11] Ibid at para 130.

[12] Ibid at para 131.

[13] Ibid at para 140.

[14] Ibid at para 128.

[15] Ibid at para 4.

[16] Ibid at para 6.

[17] Ibid.

[18] Income Tax Act, R.S.C. 1985, c. 1, s 245(5)(a).

[19] Canada, House of Commons, An Act to implement certain provisions of the fall economic statement tabled in Parliament on November 21, 2023 and certain provisions of the budget tabled in Parliament on March 28, 2023, 1st Sess, 44th Parl, 2021-2022-2023, Bill C-59 (first reading 30 November 2023) at s 245 (5.1).

[20] Ibid.

The views and opinions expressed in the blogs and case reporter are the views of their authors, and do not represent the views of the Desautels Centre for Private Enterprise and the Law, the Faculty of Law, or the University of Manitoba. Academic Members of the University of Manitoba are entitled to academic freedom in the context of a respectful working and learning environment.