Kone Inc. – Quebec Court of Appeal confirms that a cross-border repo was not an abuse of the s. 17 rule

The taxpayer (“KQI”), a Canadian operating subsidiary in the Kone multinational group, used group funds advanced to it by a group company (Kone Canada), in part as an interest-bearing loan, to purchase, for a cash purchase price of $394 million, cumulative preferred shares of a US affiliate (Kone USA) from the non-resident affiliated company (Kone BV) to which such shares had recently been issued as a stock dividend. At the same time, KQI agreed to resell such preferred shares at pre-agreed higher prices, to Kone BV in three and five years’ time, which in fact occurred. The gain arising under this resale was deemed under s. 93 to be dividends coming out of exempt surplus of Kone USA.

The ARQ sought to impute interest income to KQI under TA s. 127.6, the Quebec equivalent of ITA s. 17(1), on the basis that the above “repo” transaction was a sham that should instead be characterized as an interest-free loan by KQI to Kone BV or, alternatively, that the repo transaction represented an abusive avoidance of such s. 17 equivalent for Quebec GAAR purposes.

After rejecting the sham argument, the Court also rejected the application of the Quebec GAAR, stating:

One cannot ignore the fact that financing transactions that are not loans will not generate interest but may provide for other forms of return. … A repo with a reasonable return in the form of dividends does not defeat the OSP [object, spirit and purpose] of Section 127.6.

… KQI is taking advantage of … a mismatch between the tax treatment of its income (the dividends from Kone US are not taxable because they are paid out of its exempt surplus) and its expense (the interest in pays to Kone Canada is deductible). …

However, the mismatch arises from the Taxation Act and the policies underlying it … . The exempt surplus in Kone US is made up of its earnings from an active business on which it has already paid income taxes.

Neal Armstrong. Summaries of ARQ v. Kone Inc., 2024 QCCA 678 under s. 245(4) and General Concepts - Sham.