**Overview of Tax Court of Canada’s Ruling in DEML Investments Limited v. The King 2024 TCC 27**

DECISION HERE

In DEML Investments Limited v. The King 2024 TCC 27 (the “Case”), Justice Bruce Russell was tasked with reviewing a general anti-avoidance rule (“GAAR”) matter that involved Canadian Resource Property (“CRP”), as such term is defined in subsection 248(1) of the Income Tax Act, R.S.C., 1985, c. 1 (5th Supp.) (the “Act”).

Section 245 of the Act Generally

The purpose of GAAR is to “deny the tax benefit of certain arrangements that comply with a literal interpretation of the provisions of the Act, but amount to an abuse of the provisions of the Act” (Canada Trustco Mortgage Co. v. Canada, [2005] 2 SCR 601 at paragraph 16). Moreover, GAAR is applied to draw a line between abusive tax avoidance and legitimate tax minimization measures.

There are three factors that need to be established in order for GAAR to apply: (1) a tax benefit resulting from a transaction or series of transactions; (2) the transaction or series of transactions giving rise to the tax benefit is an avoidance transaction; and (3) the avoidance transaction giving rise to the tax benefit is abusive.

Fact Scenario

The below are pertinent facts of the Case:

The Appellant reported a substantial capital gain in its 2007 taxation year.
On January 28, 2009, the Appellant acquired the shares of 1377116 Alberta Ltd. (“137”) from Direct Energy Marketing Limited (“Direct Energy”), the Appellant’s parent corporation, at a cost of $50,688,330.00.
137 was a partner in Transglobe Energy Partnership (“DERP2”), a partnership which held resource property consisting primarily of petroleum and natural gas rights, which constitute Canadian resource property and depreciable property (the “Resource Properties”).
On January 29, 2009, 137 distributed its property which included its 99% interest in DERP2 to the Appellant.
After various transactions which the Appellant admitted were avoidance transactions under subsection 245(3) of the Act, DERP2 distributed the Resource Properties to the Appellant on January 30, 2009, as a return of capital of $59,363,463.00. “This distribution reduced the Appellant’s ACB of its DERP2 partnership interest by the said fair market value (i.e., from $50,688,431 to $(8,675,032)). The Appellant’s CCOGPE balance was increased by the fair market value of the PNG rights” (paragraph 9 of Case).
On November 30, 2010, the Appellant sold its interest in DERP2 to Orion Oil & Gas Corporation and claimed a capital loss of $45,850,237.00 (the “Capital Loss”). The Appellant reported the Capital Loss on its 2010 tax return.
“The Appellant ‘carried back’ and deducted in computing its taxable income for its 2007 taxation year $44,879,994.00 of the Capital Loss, as a net capital loss from its 2010 taxation year, to offset the capital gain the Appellant had report in its 2007 taxation year” (paragraph 9 of Case).
The Minister of National Revenue (the “Minister”) reassessed the Appellant’s 2010 and 2007 taxation years based on GAAR. In sum, on reassessment the Minister applying GAAR determined that the Capital Loss was nil and thereby reassessed the Appellant’s 2007 taxation year to deny the carry-back of the Capital Loss to 2007 to offset a capital gain. The Minister held that the application of GAAR was justified because the Appellant abused two categories of provisions of the Act, namely certain capital loss provisions of the Act, and the bump provisions of the Act.
The Appellant objected to the Minister’s reassessment on the basis that while there were avoidance transactions none of them abused or misused any provisions of the Act.

Issue

The issue before the Court was whether any of the avoidance transactions circumvented, defeated, or frustrated the object, spirit, and purpose (“OSP”) of any provisions of the Act to justify the application of GAAR by the Minister.

Reasoning and Finding

To answer the issue before the Court, the Court had to determine if the three requirements permitting a GAAR application had been met in this fact scenario.

With respect to the first requirement in the GAAR application test, the Court concurred with the Parties unanimous agreement that the Appellant did receive a tax benefit. The deduction the Appellant claimed for its 2007 taxation year of $44,879,994.00 of the total Capital Loss was a tax benefit as such term is defined in subsection 245(1) of the Act (the “Tax Benefit”).

With respect to the second requirement in the GAAR application test, the Court concurred with the Parties unanimous agreement that seven of the twelve transactional steps were avoidance transactions, as such term is defined subsection 245(3) of the Act and undertaken and arranged for the primary purpose of obtaining the Tax Benefit.

The third requirement in the GAAR application test was what was at issue in this case. There are two parts to this stage of the test, namely, first establishing the OSP of the subject statutory provision and second establishing that one or more of the avoidance transactions circumvented, defeated, or frustrated the OSP of the relevant provisions of the Act.

At this stage of the Court’s analysis, the Court examined the two abuse claims put forth by the Minister separately to see if they met the third requirement in the GAAR application test.

Capital Loss Abuse Claim

The Court held that the OSP of capital loss provisions of the Act is for a capital loss used to offset a capital gain to be reflective of “an economic loss on the disposition of property” (Triad Gestco Ltd. v. Canada, 2012 FCA 258 at paragraph 50). In other words, a loss reported cannot be artificial or paper.

The Court found that the avoidance transactions defeated the OSP of certain capital loss provisions of the Act. The primary reason was because the Appellant did not have a real or economic loss. The Court came to this conclusion because when the Appellant disposed of its interest in DERP2 to Orion Oil & Gas Corporation which created the Capital Loss, the Appellant continued to own the Resource Properties (absent the Resource Properties located in the Redwater district). As a result, the Appellant remained entitled to the Cumulative Canadian Oil and Gas Property Expenses (“CCOGPE”) and Undepreciated Capital Cost (“UCC”) tax pools pertaining to the Resource Properties while at the same time the Resource Properties increased by over $8,000,000.00 to an amount over $59,000,000.00 from when Direct Energy had purchased them. At the same time, the Appellant sought to benefit from carrying back the Capital Loss to its 2007 taxation year to offset it against the capital gain from that year. The Court found that the foregoing did not substantiate the Appellant having encountered any real loss, let alone one of $45,850,237.00.

The Court further found the Appellant abused certain capital loss provisions of the Act because the artificial Capital Loss claimed was indirectly based on CRP which is not capital property and does not have an ACB and as such it should not be an economic basis for a capital loss. Furthermore, this artificial Capital Loss was also deducted through the CCOGPE pools thereby creating a double deduction.

The Court also asserted because the Capital Loss reflected the ACB of the Appellant’s interest in DERP2 that was bumped substantially pursuant to paragraph 88(1)(d) of the Act, it further evidenced that the Capital Loss was a paper loss.

Based on the foregoing, the Court concluded that the Appellant claimed an artificial loss and thereby did not abide by the OSP of the capital loss provisions of the Act. Specifically, the avoidance transactions giving rise to the Tax Benefit abused paragraphs 3(b), 38(b) and 11(b), subparagraphs 39(1)(b)(i) and (ii) and definitions adjusted cost base in section 54 and net capital loss in subsection 111(8) of the Act.

Bump Abuse Claim

The Court found that the avoidance transactions used to obtain the Tax Benefit by increasing the Appellant’s ACB of its interest in DERP2 abused paragraphs 88(1)(b), (c) and (d), subparagraphs 39(1)(b)(i) and (ii), paragraphs 3(b), 38(b) and 111(b) and the definitions adjusted cost base in section 54 and net capital loss in subsection 111(8), subparagraph 53(1)(e)(viii), section 66.4 and subsection 66(13) of the Act. The Court’s reasoning was “it seems incomprehensible that an artificial loss would signal misuse of capital loss provisions of the Act without equally indicating misuse of the very ‘bump’ provisions of the Act used to achieve the artificial loss through the ‘bumping’ of an ACB” (paragraph 70 of Case).

Key Takeaways

One notable takeaway from this Case is that tax planning must account for the unwritten rule (not explicitly stated in the Act) that a capital loss must be economic in nature, not paper or artificial. A second notable takeaway is that a GAAR analysis is not constrained from applying to unique provisions of the Act that apply to CRP, for example; GAAR is applied to prevent a taxpayer from doing indirectly what it cannot do directly.