How the “hallmarks” apply to proposed anti-avoidance rules

Proposed changes to the Income Tax Act will oblige taxpayers to report “avoidance transactions” if the transactions include two of three existing “hallmarks.”

The underlying notion is that the hallmarks — fee, confidential protection and contractual protection — reflect circumstances that commonly exist in the context of tax avoidance transactions. Indeed, their presence indicates a greater likelihood that the transactions could be challenged under the Act’s existing general anti-avoidance rules (GAAR) in section 245. The goal is to catch those who would benefit from such transactions — including “advisors” and “promoters” who are entitled to fees.

Recently, federal draft legislation introduced section 237.3 which, if enacted, will impose new reporting obligations on people for whom a tax benefit could arise from an avoidance transaction or series of transactions (Knowledge Bureau Report, Dec. 5). Subsection 237.3(1) states transactions are “reportable transactions” if at any time an avoidance transaction as defined in subsection 245(3) is entered into by or for the benefit of a person (which includes a partnership) and any two of the following three hallmarks apply:
1. An advisor, promoter or anyone related to an advisor or a promoter has an entitlement to a fee that is to any extent:
     a) based on the amount of a resulting tax benefit;
     b) contingent upon obtaining a tax benefit or is refundable or reduced if the tax benefit is not achieved;
     c) attributable to the number of people who participate in the tax avoidance transaction or who are given access to advice or an opinion regarding the tax consequences of participating in the transaction.
2. An advisor or promoter or anyone related to an advisor or promoter has “confidential protection” in respect of the avoidance transaction; or
3. An advisor, promoter or a person who enters into an avoidance transaction has “contractual protection” in respect of the avoidance transaction.

These three hallmarks can be summarized as a “fee hallmark” which is generally based on any sort of contingency or value-based arrangement, a “confidentiality hallmark” which prevents any disclosure of the transaction to third parties, and a “contractual protection hallmark” when there is a contractual guarantee as to the tax benefit.

Fee hallmark. The fee hallmark is to be considered from the perspective of the advisor or promoter who is entitled to a fee with respect to the avoidance transaction(s) — not from the perspective of the payor.

“Fee” is defined in section 237.3(1) and encompasses any payment that is received or receivable for:
     • advising, creating, planning or documenting a transaction or series of transactions;
     • promoting or selling a plan or scheme relating to one or more transactions;
     • providing “contractual protection.”

These concepts have been criticized for their breadth and ambiguity. Of particular concern are the words “to any extent” found within this provision. This could mean that any type of billing arrangement that is not hourly or based on a time period could be caught within the ambit of this first hallmark. Since value-based billing is common in this area, many advisors fear the imposition of this section. Fee arrangements that are not abusive, they say, could be caught by this provision and it will interfere with normal commercial practices.

As a compromise, a joint committee has suggested that the fee hallmark be narrowed to fees that are “primarily” based on the amount of the tax benefit.

Confidential protection hallmark. This hallmark is present when an advisor or promoter prohibits the disclosure of details of an avoidance transaction to any person or to the Canada Revenue Agency (CRA). The Explanatory Notes accompanying the draft legislation notes that opinion disclaimers limiting an advisor’s liability to the client and disclaiming liability to third parties would not fall within this hallmark.

The enforceability of this provision, however, is suspect: many lawyers believe that solicitor-client privilege cannot be legislated away in this manner and lawyers and their clients would be free from its ambit. It is likely that solicitor-client privilege would cover certain aspect of disclosure, but would not provide blanket protection for absolutely all transactions. 

Contractual protection hallmark. This third hallmark pertains to circumstances in which the party seeking the tax benefit receives a contractual guarantee indemnifying him or her from certain penalties or liabilities that might arise from the failure to realize the intended tax benefit, such as fees, taxes, interest or even a contractual agreement whereby a promoter or advisor would set aside a litigation defence fund to cover any subsequent disputes with the CRA.

It is clear that more discussion must take place before these provisions are enacted. The difficulty with imposing such broadly phrased provisions is that their effect is uncertain until sufficient jurisprudence has examined the issue. Even then, as we have seen with the current GAAR provisions, there is no consensus as to what is prohibited and what is permissible until the judge makes a final determination because each case relies on its own facts. Uncertainty in the law and within financial transactions is never desirable.

Greer Jacks is updating jurisprudence in EverGreen Explanatory,  an online research library of assistance to tax and financial professionals in working with their clients.