Supreme Court Endorses Key Tax Principle: Tax Law Should Follow Private Law Agreements

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The Supreme Court of Canada recently endorsed a fundamental principle in Canadian tax law – namely that absent sham or statutory recharacterization rules, “tax law applies to transactions governed by, and the nature and legal consequences of which are determined by reference to, the common law or the civil law” (Québec (Agence du Revenu) v Services Environnementaux AES inc., 2013 SCC 65 at para 45). The case involved dual appeals under Québec’s civil law for what in common law terms would be a “rectification” to correct, after the fact, erroneous transaction documentation that failed to achieve the taxpayers’ objective to complete the transactions on a tax-deferred basis, as permitted by the relevant tax provisions.

The taxpayers in each case succeeded at the Supreme Court on the basis that it was the common intention of the respective parties to effect the transactions on a tax-deferred basis even though as a consequence of incorrect documentation that did not occur in the first instance. The parties were allowed to correct their documentation with effect from the original relevant dates and the corrected versions of the documentation were binding on the tax authorities.

This case may be significant beyond the rectification context insofar as it endorses the commonly understood view that tax law consequences follow the private law, such as contracts, absent sham (i.e., fraud) or explicit statutory recharacterization rules. In particular, elements of the OECD’s BEPS Action Plan and recent initiatives on transfer pricing of intangibles promote an approach that favours economic substance over legal and beneficial ownership as documented in legal agreements among member companies in a multi-national group. For example, the latest draft intangibles transfer pricing guidelines from the OECD seek to treat affiliated companies that do not own valuable IP but contribute to its value through R&D or other services as entitled to share in the residual return from IP, i.e., as the legal and beneficial owner of the IP would and not simply to an arm’s length fee for their services.

The Supreme Court’s endorsement in AES that tax results are predicated on private law contracts should assist taxpayers in defending their tax and transfer pricing planning, including respecting the legal and beneficial owner of IP as the party entitled to retain the residual return from IP, unless CRA can successfully override the arrangements through the specific recharacterization transfer pricing rule, which only applies in cases where the transactions would not have been entered into by arm’s length parties and did not have a bona fide non-tax purpose, or the general anti-avoidance rule (GAAR) directed against abusive tax avoidance transactions.