Sham Transaction Doctrine

What is the “Sham Transaction” Doctrine 

The “sham transaction” doctrine is a legal concept that has been created by the courts to apply to circumstances where a taxpayer attempts to disguise a transaction to make it appear to be something that, in reality, it is not. As a result, the doctrine is an anti-avoidance doctrine that the Canada Revenue Agency (“CRA”) may rely on to attack a transaction they suspect lacks legitimacy.  

Historical Development of the Doctrine

The modern doctrine of sham in Canada originates from the English case of Snook v. London & West Riding Investments Ltd., where the English Court of Appeal defined the legal concept as: 

“… acts done or documents executed by the parties to the “sham” which are intended by them to give to third parties or to the Court the appearance of creating between the parties legal rights and obligations different from the actual legal rights and obligations (if any) which the parties intend to create.” 

In order to meet the requirements of this definition, all parties involved in the transaction must have a common intention that the acts or documents do not create the legal rights and obligations which they give the appearance of creating. In other words, the elements of a sham require that the parties to a transaction together deliberately set out to misrepresent the actual reality of the transaction to a third party (i.e., the Minister of National Revenue).

In the Supreme Court of Canada case of Stubart Investment Ltd. v. R., the Supreme Court of Canada held that a “sham transaction” is 

“a transaction conducted with an element of deceit so as to create an illusion calculated to lead the tax collector away from the taxpayer or the true nature of the transaction.”

Therefore, for the sham doctrine to apply, there must be an element of deceit in the way that the transaction was constructed or conducted.

Sham Transactions vs. Tax Avoidance 

A sham transaction is different and distinct from transactions that can be labelled as tax avoidance transactions. Subject to the application of the General Anti-Avoidance Rule (“GAAR”) in appropriate cases, taxpayers are entitled to arrange their affairs in ways to minimize their tax burden, even if in doing so, they resort to detailed and elaborate plans that give rise to tax consequences that Parliament did not intend. Therefore, the tax avoidance transaction is lawful if the arrangement is not a sham and does not offend the GAAR. 

However, unlike tax avoidance, a sham transaction is a fraudulent transaction empowering court intervention. Courts will intervene in situations where a transaction can adequately be labelled a “sham.”

Court Interference in Sham Transactions 

The determination of whether a transaction is a sham is distinct from the correct legal characterization of a transaction. If a transaction is determined to be a sham, the Court will determine the true nature of the transaction from the extrinsic evidence (i.e., evidence other than the document(s) setting out the transaction). If the transaction is not a sham, the correct legal characterization of the transaction will be determined from the document(s) papering the transaction.

In cases where the Court finds that a transaction is a sham, it will consider the tax consequences of the actual transaction and disregard the one represented as the real transaction. This means that the Court will ignore the legal form of the sham transaction, declare the transaction a sham, and then ascertain the tax consequences of the real transaction.

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By Kaveh Rezaei – Attorney at KR Law Firm

**Disclaimer 

This article contains information of a general nature only and does not constitute legal advice. All legal matters have their own specific and unique facts and will differ from each other. If you have a specific legal question, it may be appropriate to seek the services of a lawyer.