Case Commentary: The application of the General Anti-Avoidance Rule on capital dividends

David J Rotfleisch, CPA, JD is the founding tax lawyer of Taxpage.com and Rotfleisch & Samulovitch P.C., a Toronto-based boutique tax law corporate law firm.

What is the General Anti-Avoidance Rule (GAAR) in the Canadian Income Tax Act?

The General Anti-Avoidance Rule (GAAR) is contained in section 245 of the Canadian Income Tax Act, which is designed to prevent abusive tax avoidance transactions. The GAAR allows the Canada Revenue Agency (CRA) to deny any tax benefit resulting from transactions that technically comply with the law but are primarily intended to avoid taxes in a way that frustrates the object, spirit, or purpose of the legislation.

Since its introduction in 1988, the GAAR has proven to be a powerful tool for the CRA and has greatly complicated tax planning. On June 20, 2024, the Canadian government made further amendments to the GAAR through Bill C-59, marking the most significant changes to section 245 of the Income Tax Act since the section was introduced. While most of the new rules apply retroactively to January 1, 2024, the financial penalty and the interpretive preamble are applicable only prospectively.

Given that tax litigation often takes years from commencement until a court issues a decision, there are no current case laws demonstrating how the 2024 amendment of GAAR affects Canadian taxpayers. Therefore, to better understand the impact of the GAAR, this article examines a recently released decision, Magren Holdings Ltd v Canada, 2024 FCA 202, to discuss how the previous GAAR was applied to disallow a tax benefit related to capital dividends, and to discuss how the 2024 amendment of GAAR could have impacted the same case, if the new rules would have applied.

The 2024 amendment of GAAR: Transforming GAAR to a statutory tool with very defined rules

Bill C-59 essentially transforms GAAR from a principle-driven, court-developed doctrine into a statutory tool with defined thresholds, economic substance rules, financial penalties, and enhanced enforcement powers. These changes dramatically increase the risk associated with aggressive tax planning and the CRA's power in denying various transactions. Transactions that may have been previously considered within legal bounds could now fall under GAAR's broader and more punitive scope.

To begin with, although the addition of a preamble in section 245 does not formally alter the GAAR framework, it sets out guiding principles that courts are now expected to consider when interpreting the GAAR. The preamble emphasizes that GAAR is intended to deny tax benefits arising from transactions that result in misuse or abuse of the Income Tax Act, while also recognizing the need for certainty and predictability in legitimate tax planning.

Another important change is the redefinition of what constitutes an "avoidance transaction." Prior to the 2024 amendment, GAAR required that the primary purpose of a transaction be the obtaining of a tax benefit. Under the new rules, it is sufficient that one of the main purposes of the transaction is to secure such a benefit. This subtle yet powerful change significantly broadens the scope of GAAR, as it allows the CRA to challenge transactions even if they were motivated in part by valid commercial considerations. If tax avoidance is merely one of several key purposes, GAAR can now apply.

In addition to this broader threshold, the amendments also introduce an explicit economic substance test. Previously, courts considered the presence or absence of economic substance in assessing abuse under GAAR, but it was not codified. The new legislation makes it clear that if a transaction significantly lacks economic substance, this will strongly indicate that the transaction results in misuse or abuse of the Income Tax Act.

Several indicators of such a lack include the absence of real economic risk or change for the taxpayer, a disproportionate relationship between the tax benefit and any genuine economic return, or a clear intention to achieve the tax benefit as the predominant goal. This statutory test shifts the analysis from legal form to economic reality, discouraging transactions that rely on artificial or contrived mechanisms to reduce tax liabilities.

Capital dividend issued in excess of the balance of a Capital Dividend Account

There were several corporations involved in this case, including Magren Holdings Ltd., all of which were Canadian-Controlled Private Corporations (CCPCs) controlled by Mr. James Grenon. Mr. Grenon received capital dividends aggregating more than $110 million from these corporations in 2006 and filed the required elections.

However, the distributed amount of capital dividends exceeded the amount in these corporations' Capital Dividend Account (CDA). Consequently, the CRA reassessed the corporations' 2016 taxation year, imposing Part III tax on the basis that all of the capital dividends paid in 2006 were excess dividends, relying on the GAAR.

The Tax Court of Canada (TCC) in Magren Holdings Ltd. v The Queen, 2021 TCC 42, dismissed the corporations' appeals for various reasons. First, the Tax Court of Canada found that the Part III tax assessments were valid, despite the corporations' arguments.

Specifically, the TCC held that any CRA's failure to reassess with all due dispatch did not permit the court to vacate or invalidate the reassessments that were issued beyond the normal reassessment period, citing Carter v The Queen, 2021 FCA 275. The TCC further found that the transactions giving rise to the capital gains that were allegedly included in the corporations' CDA were a sham and a misrepresentation. The corporations were also not entitled to treat the excess dividends as ordinary taxable dividends.

With respect to the application of GAAR, the Tax Court of Canada noted that "GAAR is an argument of last resort that assumes that a taxpayer has otherwise complied with the provisions of" the Income Tax Act, to which the Federal Court of Appeal agreed.

Nevertheless, both courts found that GAAR applied in this case and applied the test established in Canada Trustco Mortgage Co.: 1) existence of a tax benefit; 2) existence of a tax avoidance transaction; and 3) existence of an abusive tax avoidance transaction.

The Federal Court of Appeal ultimately concluded that the corporations achieved an outcome that the statutory provisions were intended to prevent, defeated the underlying rationale of the provisions, and circumvented the provisions in a manner that frustrated or defeated its object, spirit and purpose.

Interestingly, the Federal Court of Appeal (FCA), although upholding the TCC decision to dismiss the corporations' appeals, disagreed with some of the TCC's conclusions and "many of its obiter statements." The disagreement between the FCA and TCC demonstrated the overall complexity in the application of GAAR.

Hypothetical Scenario: What impact would the new GAAR have on Magren Holdings Ltd. if the new GAAR were in effect?

As the application for leave filed with the Supreme Court of Canada has been dismissed [ed: on June 19, 2025], the Federal Court of Appeal decision in Magren Holdings Ltd. is now final and serves as a precedent for any GAAR-related cases to which the 2024 amendment does not apply. Nevertheless, to better understand the new GAAR after the 2024 amendment, we will go through the exercise of applying the new GAAR to this case to see how it would have impacted the result of the case.

The most obvious impact would be the addition of a GAAR penalty. The corporation in Magren Holdings Ltd. was only assessed a Part III tax, which would be 60% of the excess dividends issued. The new GAAR penalty equals to 25% of the increase in taxes payable resulting from the application of GAAR. This would result in the overall penalty being 75% of the excess dividends issued, if the 2024 amendment were effective.

In Magren, the corporations argued that the reassessments of their 2006 tax year, which were issued in 2014, were statute-barred, since the normal reassessment period was three years from the date on which the CRA issued the original assessment.

As the corporations' original 2006 notices of assessment were issued all prior to December 31, 2006, the normal reassessment period would have lapsed on December 31, 2009. The 2024 amendment extended the reassessment period in application of GAAR by three years, unless the transactions were previously disclosed to the CRA. Even if the corporations' transactions were not disclosed to the CRA, the extended reassessment period would have passed by December 31, 2012. As a result, the change in reassessment period would not have had an impact on the case.

The lower threshold for the tax avoidance transaction purposes in the 2024 amendment can also have an impact on the court's reasons to dismiss the corporations' appeals, although the result would not have differed. It would be much easier for the courts to find the GAAR applies since one of the main purposes of the corporations' transactions was to obtain a tax benefit.

The courts would not need to delve into whether the transactions were a sham or misrepresentation. The economic substance rule has a similar impact as it would be reasonable for the courts to conclude that the expected value of the tax benefit, namely the distribution of tax-free capital dividends, would exceed the expected non-tax economic return from the transactions that resulted in the relevant capital gains.

In summary, the 2024 amendment would have increased the penalties assessed on the corporations and would have made it much harder for the corporations to defend their actions.

David J Rotfleisch, CPA, JD is the founding tax lawyer of Taxpage.com and Rotfleisch & Samulovitch P.C., a Toronto-based boutique tax law corporate law firm and is a Certified Specialist in Taxation Law who has completed the CICA in-depth tax planning course. He appears regularly in print, radio and TV and blogs extensively.  

With over 30 years of experience as both a lawyer and chartered professional accountant, he has helped start-up businesses, cryptocurrency traders, resident and non-resident business owners and corporations with their tax planning, with will and estate planning, voluntary disclosures and tax dispute resolution including tax audit representation and tax litigation. Visit www.Taxpage.com and email David at david@taxpage.com.

Read the original article in full on Tax Page. Author photo courtesy Rotfleisch & Samulovitch P.C. Title image: TUREK90 from Pixabay.