Ludmer – Quebec Superior Court considers equity-linked notes held in BVI company were reasonably viewed as portfolio investments held with a tax avoidance purpose, but were not reasonably viewed as being subject to 7000(2)(d) interest accrual

The Canadian-resident taxpayers were shareholders of a BVI company (“SLT”) which, in turn, held notes issued by two foreign subsidiaries of two Canadian banks. The notes were payable in 15 years’ time and the amount payable was calculated by reference to the performance of a reference portfolio of equities or bonds.

CRA considered that there was a requirement to recognize deemed interest income on the notes under Reg. 7000(2)(d) given that, in contrast to the usual equity-linked notes that were available to investors at the time, these notes had “internal puts,” i.e., SLT had the right to terminate the notes at any time, on 367 days’ notice, at the market value of the reference assets. On this basis, it considered that the “the maximum amount of interest thereon that could be payable thereunder in respect of that year” was the difference between the maximum value of the reference assets at the end of the year and the maximum value in the prior years, and assessed accordingly, to treat such annual increase as foreign accrual property income of SLT under element C of the s. 95(1) FAPI definition.

Hamilton JCS rejected the taxpayers’ submissions that it was unreasonable of CRA to assess on the basis that the notes were “portfolio investments” within the meaning of s. 94.1 (given that they were held by SLT as passive investments and they tracked portfolio investments) and also considered it reasonable to consider that tax motivation figured significantly in the structure – but then went on to find that these assessments were unreasonable, given that in its previous published positions, CRA had “never suggested that the [mere] possibility of locking-in the bonus means that an amount can be accrued based on the highest value of the index in the year.” It was also unreasonable for CRA to assess all of the increase in value of the notes in the taxation years prior to 2005 (which were statute-barred) in its reassessments for the 2005 taxation year.

In light of these and other failings by CRA, Hamilton JCS awarded the taxpayers approximately $4.8 million in damages comprised principally of interest that the large corporations were required to pay on the reassessments before they were reversed, a portion of the professional fees that were incurred in connection with the audit and, in the case of two of the individual taxpayers, $250,000 for damages to reputation (respecting a false statement made to the Bermuda authorities that CRA was conducting a "criminal" investigation) and for stress, trouble and inconvenience. Additional failures included making the unreasonable reassessments with the knowledge that they were contrary to advice received from Rulings, offering in a settlement offer to settle elements that it knew it was going to abandon, failing to honour a commitment to give notice of the reassessments and delaying disclosures under the Access to Information Act process.

Neal Armstrong. Summaries of Ludmer v. Attorney General of Canada, 2018 QCCS 3381 under s. 94.1(1), Reg. 7000(2)(d), s. 56(2), s. 152(4)(a)(i), s. 152(1) and General Concepts – Negligence.