Total Energy Services Inc. v HMK, 2025 FCA 77 – Loss-trading transactions to avoid paying tax disallowed by Tax Court of Canada (GAAR rule)

In April 2025, the Federal Court of Appeal delivered its judgment on Total Energy Services Inc. v HMK, 2025 FCA 77, upholding the decision of the Tax Court of Canada in 2024 TCC 12 in February 2024. This case affirms the application of the general anti-avoidance rule (GAAR) under section 245 of the Income Tax Act (ITA) in disallowing loss-trading transactions.

Background – a medical company “cleansed” to become an oil and gas company

This case concerns two sets of complex transactions: the restructuring transactions and the conversion transactions. At the centre, connecting these two sets of transactions, were Mr. Tonken and Mr. Matthews, two investors specialized in merger and acquisition.

In the first set of transactions (the restructuring transactions), which took place in 2007, Cavalon Capital, a corporation owned by Mr. Tonken and Mr. Matthews, invested $4.4 million in Xillix Biotechnologies, a failed medical imaging company that had sought protection under the Companies’ Creditors Arrangement Act (CCAA). Of the $4.4 million, $3.6 million was to pay off Xillix’s creditors and the remaining $800,000 was retained as capital.

Xillix no longer operated or had any assets or even a place of business. The only thing valuable about Xillix was its unused capital losses, non-capital losses, and Scientific Research and Experimental Development (SR&ED) expenditures. In return for the invested money, Cavalon received 45% of voting shares and 100% of a newly created class of non-voting shares, giving Cavalon 80% of Xillix’s equity. Other than voting, the new non-voting shares were no different from the existing voting shares; namely, they possessed the rights to dividends and to distribution on wind-up.

Xillix was then renamed Biomerge Industries, its directors and officers were replaced by Mr. Tonken and Mr. Matthews, and Biomerge was delisted from the TSX and relisted on NEX, a sub-board of the TSX Venture exchange.

Nexia Inc., another corporation owned by Mr. Tonken and Mr. Matthews, amalgamated with Cavalon to form Nexia Ltd., replacing Cavalon as the investor and shareholder in Biomerge/Xillix. Mr. Tonken and Mr. Matthews, through Nexia Ltd., marketed Biomerge as a target for acquisition with no value other than its tax attributes.

In the second set of transactions (the conversion transactions), which took place in 2009, Total Trust, a mutual fund trust, entered into an agreement with Nexia Ltd. to acquire Biomerge. Total Trust operated its oil and gas business through a subsidiary called Total Ltd. Total Trust exchanged its trust units for new common shares in Biomerge on a one-for-one basis. Total Trust also paid $3.9 million to pay off the existing shareholders of Biomerge, i.e. Mr. Tonken and Mr. Matthews, through their holdings in Nexia Ltd. as well as other public shareholders.

Biomerge was then renamed to Total Inc., and its directors and officers were replaced by those of Total Ltd. Finally, Total Trust was wound up, and Total Ltd. was merged into Total Inc. Effectively, Total Trust, a trust, was converted into Total Inc., a corporation.

Through these complicated mergers and acquisitions, Xillix became Biomerge and eventually Total Inc. The shareholding of Xillix was transferred from the original shareholders to Cavalon, to Nexia Ltd., to the unit holders of Total Trust, and eventually to the shareholders of Total Inc.

Loss-trading was disallowed

Total Inc. attempted to use the tax attributes, including unused capital losses, non-capital losses, and SR&ED expenditures inherited from Xillix. The CRA determined this to be a case of loss-trading and that the transactions violated the general anti-avoidance rule (GAAR) under section 245 of the Income Tax Act (ITA). Therefore, the CRA disallowed the tax attributes to Total Inc., which appealed to the Tax Court of Canada.

Three conditions of the GAAR

The Tax Court first reviewed the framework of the GAAR. Three following conditions must be established for the GAAR to apply:

1. Was there a tax benefit?
2. Was there an avoidance transaction or a series of transactions that included an avoidance transaction that resulted in the tax benefit? and
3. Was any of the avoidance transactions abusive?

Tax benefit is a low threshold

For the first condition, the definition of tax benefit is broad and has a low threshold. It can take any form that brings about an eventually beneficial outcome for the taxpayers, such as (a) reduction, avoidance or deferral of tax, (b) increase in refund, or (c) reduction, increase or preservation of an amount that is relevant to or results in (a) or (b).

In this case, it was not disputed that the loss carryovers and the SR&ED credits were preserved, which could result in a reduction of tax and were thus tax benefits.

One avoidance transaction must be found

For the second condition, the Tax Court explained that an avoidance transaction is one that results in a tax benefit and that one avoidance transaction, among the series of transactions, must be found.

When a tax benefit exists (the first GAAR condition), the Minister can assume that the transaction or series of transactions resulting in the tax benefit was tax-avoiding (the second GAAR condition). The burden is on the taxpayer to refute that assumption by proving that the transaction or series of transactions was undertaken primarily for bona fide purposes other than to obtain a tax benefit.

Analyzing the two series of transactions aforementioned, namely the restructuring transactions and the conversion transactions, the Tax Court found that the two sets of transactions were related, and both sets were undertaken primarily to obtain tax benefits: one to cleanse Xillix of other debts and liabilities, leaving the tax attributes as the only value for sale, and one to acquire the Biomerge/Xillix, a cleansed target with tax attributes for future use.

The taxpayer argued that the restructuring transactions were carried out not in contemplation of the conversion transactions and long before Total Trust came into the picture, and hence that the two series were not connected. The Tax Court rejected this interpretation, holding that related transactions do not require a strong nexus and that one series needs not to be carried out in contemplation of a subsequent series.

In this case, the conversion transactions were able to be executed because the target was already cleansed as a result of the restructuring transactions. That was enough to find connectedness.

The Tax Court went on to find that the two series of transactions had no bona fide purposes other than to obtain Xillix’s tax attributes.

For the restructuring transactions, Xillix was an empty shell of a company. It no longer operated or even had an asset, employee or office. The Tax Court questioned rhetorically what else Xillix could be of use except for its tax attributes. Since the two series of transactions were related, finding the restructuring transactions were tax-avoiding was already enough to satisfy the second condition of the GAAR.

The Tax Court, however, also addressed the argument of the taxpayer that the conversion transactions were not to acquire the tax attributes, but to convert Total Trust to a corporation; the tax attributes were just icing on the cake.

The Tax Court dismissed this argument. There are better, simpler, cheaper, and more efficient ways to achieve that goal, e.g. by simply incorporating a new corporation, converting Total Trust itself to a corporation, or continuing as Total Ltd. (the subsidiary corporation of Total Trust).

The Tax Court again posed a rhetorical question as to why Total Trust needed to go through all the hassle of paying almost $4 million, if not for the tax attributes of Biomerge/Xillix.

Loss-trading is abusive

For the third condition, to determine if the avoidance transaction is abusive, the analysis must identify the object, spirit and purpose (OSP) of the relevant provisions and whether the avoidance transaction frustrates the said object, spirit and purpose.

The relevant provisions here are subsection 111(4) regarding net capital losses, subsection 111(5) regarding non-capital losses, and subsection 37(6.1) regarding SR&ED deductions in the Income Tax Act (also known as the loss-streaming rules).

The Tax Court affirmed the tax jurisprudence that the object, spirit and purpose of loss-streaming rules is to deny unused losses to unrelated third parties who acquire control of the corporation that experienced those losses.

The provisions on loss-streaming rules do not specify the kind of control to be acquired for the rules to operate. But jurisprudence interpreted “control” in this respect broadly, as any kind of control so as to achieve the avoidance transaction, regardless of nomenclature – being de jure, de facto, actual, necessary or functional control.

In this case, Mr. Tonken and Mr. Matthews, through Cavalon/Nexia, acquired 45% of voting shares of Xillix in order to avoid the prima facie finding of de jure control (which typically requires holding of at least 50% of voting shares).

Nevertheless, Mr. Tonken and Mr. Matthews held 80% of the equity of Xillix and were able to completely transform Xillix by changing its name (to Biomerge), share structure, directors and officers. Likewise, Total Trust completely transformed Biomerge by changing its name (to Total Inc.), share structure, directors and officers, as well as its line of business (from biotech to oil and gas).

The public shareholders of Xillix/Biomerge had no other option than to acquiesce to the plans laid out by Mr. Tonken, Mr. Matthews, and Total Trust if they wished to get something out of their investments in a failed company.

The Tax Court concluded that the avoidance transactions tried to transfer the unused losses from Xillix to the hands of Mr. Tonken and Mr. Matthews and then to Total Trust, all unrelated parties to Xillix, thus clearly frustrating the loss-streaming rules.

Pro Tax Tip – GAAR is effective against sophisticated schemes

The Tax Court ultimately ruled that these complex transactions satisfied the three conditions of the general anti-avoidance rule (GAAR), specifically:

1. There was a tax benefit;
2. The transactions were for no other purpose than to seek a tax benefit by making use of the unused losses; and
3. The transactions were effected to frustrate the loss-streaming rules.

Therefore, the taxpayer (Total Inc.) was denied the unused losses incurred by Xillix. The taxpayer appealed to the Federal Court of Appeal. The Federal Court of Appeal upheld the decision of the Tax Court, finding no error by the Tax Court that could warrant a deviation from jurisprudence on loss-trading.

This case is a reminder that the GAAR is a broad mechanism that can be very effective against undesirable tax outcomes sought by sophisticated schemes. Taxpayers should always consult with experienced Canadian tax lawyers to examine the potential application of the GAAR when contemplating tax planning transactions.

FAQ

My transactions did not reduce my tax liability or increase my tax refund when the transactions took place. Can the GAAR apply?

The GAAR can apply where there is a tax benefit. A tax benefit is not limited to tax reduction or refund at the time the transaction takes place. It also includes the preservation of amounts, such as unused losses, which can be used at a later time to produce a tax reduction or refund. Therefore, taxpayers should retain experienced Canadian tax lawyers to carefully review their tax planning.

My transactions achieve another purpose besides gaining a tax benefit. Can the GAAR apply?

A transaction or arrangement can accomplish multiple purposes, including gaining a tax benefit. In determining whether the transaction or arrangement is tax-avoiding, the court will consider if there is a simpler, cheaper, more efficient alternative to accomplish the bona fide purpose(s).

When the answer is positive, it is likely that the taxpayer decided to go through the more complicated, costly route to gain the tax benefit, satisfying the GAAR’s conditions. Thus, taxpayers should seek help from experienced Canadian tax lawyers in tax planning, preventing the application of the GAAR.

DISCLAIMER: This article just provides broad information. It is only up to date as of the posting date. It has not been updated and may be out of date. It does not give legal advice and should not be relied on. Every tax scenario is unique to its circumstances and will differ from the instances described in the article. If you have specific legal questions, you should seek the advice of a Canadian tax lawyer.