News of Note
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
Email this ContentThe 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).
Catlos – Tax Court of Canada finds that a s. 8(1)(b) deduction was unavailable respecting a defence to shareholders’ claims of unjust enrichment including excessive salaries
Russell J was prepared to accept a dictum in Fenwick that the deduction under s. 8(1)(b) for establishing a right to receive remuneration extended to an employer seeking a return of remuneration paid, but found that s. 8(1)(b) did not extend to legal fees incurred in defending against claims made against individuals who were officers and shareholders of a private company for allegations of unjust enrichment and breach of fiduciary obligations to the other shareholders – notwithstanding that success of such claims likely would have required them to “disgorge” their allegedly excess remuneration.
Neal Armstrong. Summary of Catlos v. The Queen, 2018 TCC 177 under s. 8(1)(b).
CRA considers the Treasury Board per-kilometre travel rates to always be “fair and reasonable”
In connection with confirming that for medical expense tax credit purposes regarding medically-necessary travel, CRA uses the per-kilometre rates set by the National Joint Council (NJC) of the Public Service of Canada (which have been adopted by the Treasury Board), CRA stated:
The CRA has always accepted the NJC rates as fair and reasonable. The NJC determines the rates by analyzing new vehicle prices, depreciation and financing rates, current fuel prices, insurance premium rates, and operating costs in each province or territory.
Neal Armstrong. Summary of 12 July 2018 Ministerial Correspondence 2018-0761301M4 under s. 118.2(2)(h).
Finance issues comfort letter respecting provision of a deemed repayment rule for B2B loans under s. 90(7)
The upstream loan regime in s. 90 provides for income inclusions under s. 90(6) for certain loans and indebtedness owing to FAs, and offsetting deductions on repayment under s. 90(14). The rules contain back-to-back loan (B2B) provisions in s. 90(7). Finance was provided with an example where a B2B loan from an foreign affiliate of Canco to Forco 1 and by Forco 1 to Forco 2 (both specified debtors respecting Canco but not foreign affiliates) was repaid, and a fresh loan was made to a third specified debtor respecting Canco. The concern was expressed that the repayment of such B2B loan would not result in repayment of the deemed direct loan under s. 90(7) from Canco to Forco 2, so that Canco would face double income inclusions from the still-outstanding deemed loan and from the new actual loan.
As foreshadowed at the 2018 IFA Finance Roundtable, Q.10, Finance indicated that it was recommending to the Minister that there be new repayment rules (effective for repayments after April 10, 2018) similar to the ones in s. 15, so as to eliminate a second income inclusion under the (now deemed-repaid) B2B loan. In particular, what is recommended are:
rules - similar to the deemed repayment rules in subsections 15(2.18) and (2.19) (which apply for the purposes of the back-to-back shareholder loan rules in subsections 15(2.16) and (2.17), but with such modifications as are required by the context of the upstream loan rules - that would deem all or a portion of a loan that is deemed to be made under subsection 90(7) to be repaid for the purposes of paragraph 90(8)(a) and subsection 90(14) if certain conditions are met.
These conditions would be similar to those in subsection 15(2.18). In general terms, a loan deemed to have been made under subsection 90(7) would be deemed to be repaid, in whole or in part, as a result of certain repayments, in whole or in part, of one or both of the loans between the "initial lender" and the "intermediate lender", and the "intermediate lender" and the "intended borrower" (as those terms are defined in subsection 90(7)).
Neal Armstrong. Summary of May 1, 2018 Finance Comfort letter under s. 90(14).
CRA’s published position on the imposition of branch tax on U.S. LLCs with non-resident U.S.-citizen members may not reflect its assessing practice
In response to a recent post on the hybrid rules in the Canada-U.S. Treaty, a correspondent suggested that the reference made in the post to the published CRA position on the imposition of Canadian branch tax on U.S. LLCs with a Canadian business does not reflect CRA’s actual assessing practices. Art. X(6) provides:
“Nothing in this Treaty shall be construed as preventing [Canada] from imposing a tax on the earnings of a company attributable to permanent establishments in [Canada], in addition to the tax which would be chargeable on the earnings of a company which is a resident of [Canada], provided that any additional tax so imposed shall not exceed [5%]… .”
Because Article X(6) only refers to “companies”, CRA has stated that it does not operate to reduce the branch profit tax rate on income that is deemed to have been derived by non-corporate LLC members through the LLC.
The point made was that, contrary to this view, Art. X(6) is not a relieving provision, but is instead an exception to Art. XXV which, inter alia, prevents Canada from subjecting U.S. nationals (e.g., U.S. citizens or companies) to taxation in Canada that is more burdensome than that imposed on Canadian nationals – as signalled by the Art. X(6) preamble, which states that it applies notwithstanding anything else in the Convention (i.e., Art. XXV) (thereby permitting the 5% branch tax to be imposed on U.S. companies).
A December 2013 article on this point states:
[T]he alternative interpretation advocated in this article, to the effect that Article X(6) serves as an exemption to the non-discrimination provisions contained in Article XXV of the Treaty and only permits Canada to impose a 5% branch profits tax on corporations, is, we would submit, entirely consistent with both the text and the spirit of the Treaty.
We are aware of several instances recently (either at the audit or the objection stage) where the CRA has backed away from its published views on the branch profits tax provisions, and instead opted to apply the interpretations advocated herein.
Neal Armstrong. Summary of Carl Irvine and Todd Miller, "Canadian Branch Profits Tax - Challenging the Denial of Treaty-Benefits for US LLCs," Newsletter - TerraLex Connections, 26 December 2013 under Treaties – Income Tax Conventions – Art. 4.
Income Tax Severed Letters 5 September 2018
This morning's release of three severed letters from the Income Tax Rulings Directorate is now available for your viewing.
CRA accepts that a significant arm’s length investment in a related corporation that will purchase the assets retained under a s. 55(3)(a) spin-off did not occur as part of the series
Mother along with an arm’s length business associate (“Investor”) wanted to use some of the assets of the family business corporation (“Amalco”) to engage in some sort of development project, whereas her daughter did not want any part of this. Accordingly, it was agreed that one of the two businesses would be spun off to the Daughter’s Newco under s. 55(3)(a). It was also contemplated that thereafter the business retained by Amalco would be sold by Amalco at fair market value to a recently formed development company (XCo) which was controlled by Mother but in which Investor had made a significant equity investment.
This investment by Investor would have jettisoned s. 55(3)(a) treatment of the spin-off by virtue of s. 55(3)(a)(ii) if it had been considered to have occurred as part of the same series of transactions. However (before giving a s. 55(3)(a) ruling of sorts), CRA accepted a representation that:
The Acquisitions [including Investor's equity investment] did not rely on the Proposed Transactions in order to produce a given result. The Proposed Transactions will not rely on the Acquisitions to produce a given result.
In addition ... the Acquisitions ... would have been undertaken irrespective of whether any of the Proposed Transactions will be implemented..
Neal Armstrong. Summary of 2018 Ruling 2017-0683941R3 under s. 55(3)(a)(ii).
Solar Power. v. ClearFlow - Ontario Court of Appeal confirms that a daily discount fee had the 3 attributes of interest
A typical loan made by the lender (ClearFlow) to the borrower bore base interest rate of 12% p.a. compounded monthly, an administration fee that was charged when the Loan was initially advanced, and each time it renewed (of, say, 1.81% of the loan balance), and a “discount fee” of 0.003% per day of the outstanding principal. Sharpe JA confirmed the finding of the application judge that the administration fee was not interest, as well as his finding that the discount fee was interest, stating:
[T]he amount of the fee did not vary according to the administrative work required by the loan as in the case of the administrative fee, and the fee was charged at a daily fixed rate unrelated to any ongoing or specific events… [It] bore all the hallmarks of the test for interest: it was consideration or compensation for the use of money, it related to the principal amount, and it accrued over time.
He went on to find that the disclosure of the “rate” of such interest through the provision of a simple formula complied with s. 4 of the Interest Act. For this and other reasons the borrower was unsuccessful in its arguments that the total interest under the loan was subject to a 5% cap imposed under s. 4.
For a borrower whose business in not money-lending or something similar, the distinction between a fee and interest informs whether deductibility of a lender's charge is to be analysed under s. 20(1)(e) or (e.1), or under s. 20(1)(c).
Neal Armstrong. Summary of Solar Power Network Inc. v. ClearFlow Energy Finance Corp., 2018 ONCA 727 under s. 20(1)(c).
Custeau – Court of Quebec finds that GAAR did not apply where individuals used PUC thrust upon them by an arm’s length investor (through PUC averaging) to subsequently strip surplus
When the taxpayers’ corporation (“Opco”), a small business corporation, was in financial difficulty, a Quebec regional development fund agreed to inject equity capital in Opco on terms dictated by the fund – which entailed the fund investing in the common shares of Opco, so that the paid-up capital of the taxpayers’ shares was boosted from a nominal amount to $1.45 million. About five years later, the taxpayers engaged in capital gains crystallization transactions in which they transferred most of their common shares of Opco to personal holding companies, realizing capital gains of $1 million, and took back preferred shares with a correlative adjusted cost base and also a paid-up capital that reflected the earlier step-up in the transferred shares’ PUC. Following the repurchase of all of the fund’s common shares of Opco, the taxpayers’ had their Holdcos distribute most of the PUC of their preferred shares in cash.
The ARQ considered there to have been abusive surplus-stripping, and applied the Quebec general anti-avoidance rule to treat most of the paid-up capital distributions as taxable dividends. Dortélus JCQ found both that there had been no avoidance transaction (with his focus being on the boosting of the paid-up capital of the taxpayers’ shares), and that there was no abusive tax avoidance.
Respecting his first finding, he noted that the increase in the taxpayers’ PUC was not their doing but was a result of terms imposed by the fund, and that at that time it was “financially inconceivable” that Opco would be able to turn around within six years so as to both redeem out the fund at a large gain to it and fund the distribution of the taxpayers’ PUC.
Respecting his second finding, he accepted the taxpayers’ submission that Pomerleau and 1245989 were distinguishable on the basis that in those two decisions “the surpluses were stripped as part of ‘internal’ transactions between individuals and corporations not dealing at arm’s length, which is not the case here, as there is an arm’s length relationship between the plaintiffs and [the fund].”
Neal Armstrong. Summaries of Custeau v. Agence du revenu du Québec, 2018 QCCQ 5692 under s. 245(3) and s. 245(4).
Where an LLC has a Canadian business, it may be advantageous for U.S. members to hold their membership interests through S Corps
Art. IV(6) of the Canada-U.S. Treaty does not provide Treaty benefits to non-U.S. residents (including Canadians) investing through an LLC. This extends to the situation where the LLC carries on business in Canada but does not have a Canadian permanent establishment, so that only the income allocable to the LLC's U.S. resident members would be exempted under Art. VII. Where U.S. resident individuals invest through an LLC, CRA considers that the pro rata share of branch earnings attributable to them should be subject to branch tax at the statutory 25% rate rather than the Treaty-reduced 5% rate, since the relieving provisions in Art. X(6) are only applicable to corporations. This might be addressed by interposing S Corps (viewed by CRA as Treaty residents notwithstanding their U.S. tax transparency) as the members of the LLC.
Neal Armstrong. Summary of Julie Colden and Éric Lévesque, “An In-Depth Look at the Hybrid Rules in the Fifth Protocol,” 2017 Annual CTF Conference draft paper under Treaties – Income Tax Conventions – Art. 4.