Loblaw Financial – Tax Court of Canada finds that a Barbados bank subsidiary did not satisfy the FAPI-exclusion test of conducting an arm’s length business (there was no competitor), and narrowly construes the “series” concept

The taxpayer, an indirect wholly-owned subsidiary of Loblaws, wholly-owned a Barbados subsidiary (GBL), that was licensed in Barbados as an international bank and that used funds mostly derived from equity injections by the taxpayer to invest in U.S.-dollar short-term debt obligations, loans to several thousand independent U.S. distributors of Weston baked goods and intercorporate loans – and entered into cross-currency and interest rate swaps with an arm’s length bank to effectively convert much of its income stream into fixed rated Canadian-dollar interest. CRA assessed the taxpayer on the basis that GBL had realized $473 million of foreign accrual property income (FAPI) between 2001 and 2010.

C Miller J found that GBL met the requirement, in the exclusion from the investment business definition, of being a foreign bank given that it was licensed in Barbados as an international bank. GBL also satisfied the further test, for the exclusion to apply, that the business employ the equivalent of more than five full-time employees in its active conduct (given that some time spent by its employees in servicing related affiliates, as described in s. 95(2)(b)(i), was not sufficient to reduce the equivalent number to below this threshold). However, he nonetheless confirmed the assessments on the basis that such business was conducted principally with the Loblaw group (i.e, it was not conducted principally with arm’s length persons.) “In looking at both aspects of a foreign bank’s business [namely] the receipt of funds and use of funds, there should be emphasis on the receipt side as that is where one would expect to find the completion element.” GBL clearly flunked on the receipt side (its funds came from Loblaw - although no authority was cited for the proposition that equity funding was part of the conduct of a business) and, even on the fund use side, the purchases of the short-term debt were impressed with their character of researching the best return for a non-arm’s length party, the distributor loans “were effectively handed over to GBL by Loblaw,” the intercompany loans clearly were with non-arm’s length persons and “even the swap activity has a considerable element of conducting business with non-arm’s length person, as the swaps were subject to Loblaw derivative policies.”

In finding that GBL realized foreign exchange gains and losses under s. 95(2)(f) on its U.S.-dollar denominated short-term debt portfolio on income account, he stated:

The acquisition of the short term securities, taking their yield and funding a derivatives program to produce a greater yield is … using these short term securities in a manner akin to inventory in an income producing scheme.

Now, for some obiter. He found that CRA would have been statute-barred from applying the general anti-avoidance rule (GAAR) to the pre-2008 taxation years of the taxpayer and that, even for the 2008-2010 years, GAAR would not have been applicable had he concluded that the GBL income was not FAPI. He appeared to consider that CRA could only assess those open years if there was a relevant avoidance transaction that occurred in those (rather than the earlier statute-barred) years. The only mooted transaction in those years was the renewal of GBL’s international banking licence. Was this renewal part of a “series of transactions” that constituted an avoidance transaction? In this regard, C Miller J focused most on the hiring of three employees by GBL in 1994, which appeared to be motivated by the legislative adoption of the investment business definition containing the five full-time employees test, and stated that this was “a one-off transaction that has no bearing beyond the year in which it occurred.” Instead the relevant series was that of the taxpayer engaging in an offshore investment strategy “in a low tax jurisdiction with a recognized international financial infrastructure” with a view to avoiding FAPI, and the bona fide commercial purpose therein outweighed the FAPI-avoidance objective.

It thus would have been unnecessary to consider “misuse" or "abuse” under s. 245(4). However, he indicated (in what you might term 2nd-tier obiter) that there would have been such misuse:

The policy, or underlying rationale, of the exemption … is to promote competition of affiliates operating in international markets. …

[I]t follows that Loblaw Financial was misusing this exemption as it was not competing in any manner in any international market. It basically managed an investment portfolio for Loblaw.

Neal Armstrong. Summaries of Loblaw Financial Holdings Inc. v. The Queen, 2018 TCC 182 under s. 165(1.11), s. 95(1) – foreign bank, investment business, para. (a), para. (c), s. 9 – capital gain v. profit – foreign exchange, s. 152(4.01)(a)(ii), s. 245(3), s. 248(10), s. 245(4), s. 95(2)(l).