Executive Summary: Key Legal and Evidentiary Issues

• Application of the General Anti-Avoidance Rule (GAAR) to deny a capital loss claimed from complex corporate transactions.

• Examination of whether the capital loss was artificially created through the use of the “bump” provisions in paragraphs 88(1)(c) and (d) of the Income Tax Act.

• Assessment of the interplay between the adjusted cost base (ACB) bump and cumulative Canadian oil and gas property expense (CCOGPE) pools.

• Determination of whether technical compliance with statutory provisions frustrated the object, spirit, and purpose of the law.

• Clarification of the portion of the capital loss attributable to partnership income allocation versus the ACB bump.

• Final adjustment of the denied capital loss based on the Court’s analysis, limiting the GAAR’s application.

Facts of the case

DEML Investments Limited (DEML), a subsidiary of Direct Energy, became involved in a series of transactions related to the acquisition and sale of oil and gas resource properties originally owned by Transglobe Energy Corporation. In 2008, Direct Energy acquired shares in two Transglobe subsidiaries, which had formed a partnership (DERP 2) and transferred Canadian resource properties and depreciable property into it. These transactions involved a series of tax elections and reorganizations, including the use of subsection 85(1) and 97(2) elections to set transfer values for tax purposes.

After the acquisition, DEML received the shares of the subsidiaries and, following a winding-up, obtained a partnership interest in DERP 2. DEML then applied the “bump” provisions under paragraphs 88(1)(c) and (d) of the Income Tax Act, increasing the adjusted cost base (ACB) of its partnership interest. The partnership distributed the resource properties to DEML, and further transfers occurred, including the eventual sale of the partnership interest and shares to Orion Oil and Gas Corporation in 2010. DEML claimed a capital loss on this sale and carried back the net capital loss to offset a taxable capital gain from a previous year.

Discussion of policy terms and statutory clauses

The dispute centered on the application of section 245 of the Income Tax Act, known as the General Anti-Avoidance Rule (GAAR), which allows the Minister to deny tax benefits arising from abusive tax avoidance. The “bump” provisions in paragraphs 88(1)(c) and (d) were also at issue, as they permit an increase in the ACB of certain property acquired on the winding-up of a subsidiary. The case also involved provisions related to capital losses, the definition of capital property, and the treatment of Canadian resource properties and partnership interests, particularly the cumulative Canadian oil and gas property expense (CCOGPE) rules.

Proceedings and decisions in the Tax Court and Federal Court of Appeal

At the Tax Court, DEML conceded that a tax benefit arose and that certain transactions were avoidance transactions. The main issue was whether these transactions were abusive within the meaning of the GAAR. The Tax Court found that the transactions abused the capital loss and bump provisions, as they resulted in an artificial loss while DEML retained the underlying resource properties and continued to benefit from the CCOGPE pools. The Tax Court dismissed DEML’s appeal, denying the entire capital loss.

On appeal, the Federal Court of Appeal focused on whether the entire capital loss should be denied or only the portion attributable to the ACB bump. The Court found that only the portion of the loss attributable to the bump ($39,402,330) should be denied under the GAAR, while the portion attributable to the allocation of partnership income ($9,084,659) should not be denied, as denying it would result in double taxation. The Court analyzed the object, spirit, and purpose of the bump provisions, concluding that they are intended to prevent double taxation when a parent company winds up a subsidiary and acquires its assets, but not to allow a taxpayer to benefit from both an increased ACB and continued access to CCOGPE pools for the same properties.

Ruling and outcome

The Federal Court of Appeal allowed DEML’s appeal in part, setting aside the Tax Court’s judgment and referring the matter back to the Minister for reassessment. The Court directed that only the portion of the capital loss attributable to the bump should be denied, reducing the net capital loss that DEML could carry back. No costs or damages were awarded to either party in this appeal or in the Tax Court.