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The Queen v. Remai – A new take on “arm’s length”

The Federal Court of Appeal has recently confirmed that a taxpayer and a company controlled by the taxpayer’s nephew are considered to “act at arm’s length” in a transaction where the nephew’s company purchases promissory notes from a charity controlled by the taxpayer only to help the taxpayer solve a tax problem.

The Queen v. Remai 2009 FCA 340 involved a charitable donation plan in which the taxpayer, Frank Remai, endorsed $15M worth of notes payable to him from FRM, his wholly-owned company, to the Frank and Ellen Remai Foundation, a charitable Foundation which Frank controlled.  Unbeknownst to the taxpayer, such plans had already been shut down in 1997 with the enactment of paragraphs 118.1(13)(a) and 118.1(18)(a) of the Income Tax Act (the “Act”). These paragraphs made gifts of “non qualifying securities” ineligible for the charitable tax credit. Once the taxpayer realized he could not claim the credit, he attempted to rectify the problem by falling under the relieving provision of paragraph 118.1(13)(c) of the Act. (Under paragraph 118.1(13)(c), a non-qualifying security ceases to be “non-qualifying” if the charity sells the gifted security to a third person with whom the donor deals at arm’s length.) Accordingly, the Foundation sold the notes for their face amount to Sweet, a company that was controlled by Frank’s nephew. Frank then claimed the charitable donation credit on the assumption that the notes were no longer “non-qualifying” within the meaning of 118.1(13)(c).

The Minister disallowed the charitable donation credit, and the taxpayer’s estate appealed to the Tax Court of Canada, where it was held that the taxpayer properly claimed the charitable donation credit. The Minister then appealed to the Federal Court of Appeal, which examined whether the Tax Court of Canada had properly concluded that the parties were dealing at arm’s length and that the general anti-avoidance rule (“GAAR”) did not apply.

In this case, Frank and Sweet were not related. Thus, paragraph 251(1)(a) – the rule which deems related persons not to be dealing at arm’s length – did not apply. Moreover, as no personal trust was involved, paragraph 251(1)(b) did not apply. The question was how to apply paragraph 251(1)(c), which provides as follows:

(c) where paragraph (b) doesn’t apply, it is a question of fact whether persons not related to each other are at a particular time dealing with each other at arm’s length.

The trial judge interpreted paragraph 251(1)(c) as being applicable when only paragraph 251(1)(b) was not. In other words, he assumed that paragraph (c) could not apply if both paragraphs (a) and (b) were not applicable. The Federal Court of Appeal rejected his interpretation of 251(1)(c). If paragraph (c) doesn’t apply when paragraphs (a) and (b) don’t apply, when would paragraph (c) ever apply? Parliament cannot be presumed to intend provisions to have no practical application. On the contrary, a study of the legislative history of the provision revealed that paragraph (c) was intended to apply in cases not covered by paragraphs (a) and (b). Remai is an interesting example of how the text of a provision plays a lesser role when there is an error or ambiguity in legislative drafting. Indeed, as the Court put it:

“The less than perfect drafting of the provision does not warrant an interpretation that makes a nonsense of the subsection and takes no account of its history, purpose, or structure.”

Although the trial judge had decided that paragraph 251(1)(c) was inapplicable, he nonetheless went on to analyze whether Frank and Sweet, though unrelated, were dealing at non arm’s length. In doing so, he considered the test developed under Peter Cundill & Associates Ltd. v. The Queen [1991] 2 CTC 221 for determining whether unrelated parties are acting at arm’s length, namely, whether: (i) there was a common mind directing the bargaining for both parties; (ii) the parties were acting in concert without separate interests; and (iii) one party exercised defacto control over the other.

The trial judge applied the Cundill factors in quite a taxpayer friendly manner, holding that there was no “common mind” directing the bargaining for both parties in this case because Sweet was not directly or indirectly controlled by Frank, and it freely entered into the transaction after considering its own interests. In this regard, the Federal Court of Appeal held the trial judge committed no “palpable and overriding error”, even though the Federal Court of Appeal noted that Frank entirely drove the proposal, the purpose of which was to benefit him and his Foundation, and that there was no bargaining over the terms of the exchange. (The Federal Court of Appeal noted that the standard of “palpable and overriding error” does not warrant interference by an appellate court merely because the appellate court would have reached a different conclusion if it had been the trier of fact.)

In analyzing factor (ii), both the trial judge and the Federal Court agreed that the parties had “separate interests,” given that Frank’s nephew only entered into the transaction after first ensuring that Frank’s company could honor the notes. The conclusion under factor (ii) is frankly a little surprising. Sweet seemed to have nothing to gain in the transaction, and largely entered into it as a favor to Frank. Yet, both levels of court agreed that the fact that Sweet first ensured that it wouldn’t lose the $15M required to help out the taxpayer reflected a “separate interest”.

With respect to factor (iii), the Federal Court of Appeal agreed with the trial judge that while Frank no doubt “exercised a degree of influence” over his nephew given their family relationship and their business connections, this did not amount to defacto control over Sweet. Indeed, Frank and Sweet’s business dealings had been mutually beneficial and Sweet was not entirely dependent on Frank for its business.

Finally, the Federal Court of Appeal held that the trial judge committed no palpable and overriding error in concluding that there had been no abuse under the GAAR. Relying on writings by tax authors, the Federal Court of Appeal held that the purpose of paragraph 118.1(13)(c) and subsection 118.1(18) was to disqualify certain gifts from a charitable tax credit because of the practical difficulty of assessing their fair market value. In this case, the sale price paid by Sweet provided a reliable basis for assessing the fair market value of the notes, and thus, the purpose of the relevant provisions was not frustrated. The Crown argued that the purpose of the relevant provisions was rather to prevent donors from claiming a charitable credit for the value of a gift when they retained control of the funds from which the gift would be satisfied. While the 1997 Budget appeared to support the position of the Crown, (the budget stated that the new measures would deal with loan-backs which had been used to enable taxpayers to claim tax credits for charitable gifts without having to forego use of the funds), the Federal Court of Appeal rejected the Crown’s position. The Court was not persuaded that preventing taxpayers from claiming a charitable tax credit where the taxpayer doesn’t forego the use of gifted funds was the purpose of the relied on provisions. In any event, the Court noted that Frank no longer retained control of the gifted funds once the promissory notes were sold to Sweet.

Although surprising in some respects, Remai is a welcome development for taxpayers.