Ludmer v. Attorney General of Canada, 2018 QCCS 3381, aff'd 2020 QCCA 697

Two of the taxpayers (“Ludmer” and Steinberg”) were invested along with family, friends and acquaintances (all resident in Canada) in a BVI company (“SLT”) whose investments were managed by a non-resident hedge fund manager (“GAM”). When GAM proposed that SLT be merged with another fund managed by GAM in which non-residents were investors, it was agreed that, in light of the merged fund being subject to a higher level of fees than those to which SLT had been subject, that a Bermuda company owned indirectly by two Steinberg and Ludmer non-resident trusts would receive annual “fees” from the time of the 1994 merger that effectively represented a rebate of the higher fees imposed on the Canadian investors (although they were described to be consideration for services that, in fact, were never provided). This arrangement was replaced in 2007 by a new agreement in which the “fees” were paid directly to two newly-established Canadian-resident family trusts.

In finding that it was not unreasonable for CRA to assess on the basis that these payments were includible in the income of Steinberg and Ludmer under s. 56(2), Hamilton JCS stated (at paras. 614-615):

The GAM payments were not in the nature of a windfall. They were made pursuant to a contract. They were enforceable, organized, foreseeable and customary since 1995. … [T]he contracts provided for services to be provided as consideration for the payments. …

The argument put forward ... that they are “nothings” for Canadian tax purposes because they are merely reputational payments arising in a non-business circumstance may ultimately be upheld by the Tax Court, but it is not so clear at this stage as to render the CRA’s position unreasonable.

Two of the taxpayers (“Ludmer” and Steinberg”) were invested along with family, friends and acquaintances (all resident in Canada) in a BVI company (“SLT”) whose investments were managed by a non-resident hedge fund manager (“GAM”). When GAM proposed that SLT be merged with another fund managed by GAM in which non-residents were investors, it was agreed that, in light of the merged fund being subject to a higher level of fees than those to which SLT had been subject, that a Bermuda company owned indirectly by two Steinberg and Ludmer non-resident trusts would receive annual “fees” from the time of the 1994 merger that effectively represented a rebate of the higher fees imposed on the Canadian investors (although they were described to be consideration for services that, in fact, were never provided). This arrangement was replaced in 2007 by a new agreement in which the “fees” were paid directly to two newly-established Canadian-resident family trusts.

In finding that it was not unreasonable for CRA to assess on the basis that taxation years beyond the normal reassessment period were open to reassessment and that gross negligence penalties could be imposed for failure to report the amounts for inclusion in the hands of Steinberg and Ludmer under s. 56(2) or 246(1), Hamilton JCS stated (at paras. 637-638):

It is fair to infer that their lawyers created the Sandringham structure and drafted the contracts and that they advised Ludmer and Steinberg that they were not required to pay any tax. However, the legal advice was not produced and therefore the facts on which the advice was based and any limitations on the advice are not before the Court. Moreover, there is also the issue of the contracts which state that Sandringham was receiving the payments in consideration for “investment consultancy services”. Ludmer and Steinberg now argue that no such services were ever provided and it was never the intention to provide such services, suggesting that the contracts were shams. Ludmer and Steinberg must have known that the contracts were shams. It is difficult to reconcile the sham contracts with legal advice.

In these circumstances (very substantial payments, no tax, no disclosure, sham contracts and reliance on legal advice not produced), and subject to the comments below in the section entitled “Settlement offer”, the Court is of the view that the CRA’s position on opening up statute-barred years and penalties is not unreasonable. It will be for the Tax Court to decide.

Hamilton JCS found that the Montreal TSO had acted improperly in making unreasonable reassessments that were contrary to advice received from Rulings and by offering in a settlement offer to settle elements that it knew it was going to abandon (summarized at para. 702).

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 (“BNSIL” and “TDII”). 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, stating (at paras. 364-366):

[T]he term “portfolio investments” describes the nature of the investments as opposed to the number of investments (that would be “portfolio of investments”) or the number of trades. …

[T]he Notes… are investments by SLT in debt instruments of BNSIL and TDII, which are non-resident entities. SLT does not exercise any influence or control over the Notes or the issuers of the Notes. Rather, SLT wishes to passively benefit from the appreciation in value of the Notes.

In any event, the SLT shares are OIF caught by Section 94.1 ITA if they may “reasonably be considered to derive [their] value, directly or indirectly, primarily from portfolio investments of that or any other non-resident entity”. It is clear that the shares of SLT derive their value indirectly from the Reference Assets.

In also considering that it was reasonable for CRA to consider that the tax motive referenced in s. 94.1 was present, he noted that the shareholders of SLT, a BVI company, were Canadian residents, and that they had participated in a 2001 reorganization to avoid adverse Canadian tax consequences of proposed “FIE” rules, and stated (at para. 382):

It is difficult to understand what exactly the Plaintiffs would argue to say that tax consequences were not one of the reasons for the original incorporation in the British Virgin Islands or the 2001 reorganization. They have had ample opportunity to present any relevant evidence and they have not done so.

However, in nonetheless going on to find that these assessments were unreasonable, Hamilton JCS found 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” (para. 439). It was also unreasonable for CRA to assess all of the increase in value of the Note in the taxation years prior to 2005 (which were statute-barred) in its reassessments for the 2005 taxation year.

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 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.

In finding that these assessments were unreasonable, Hamilton JCS stated (at paras. 438-440):

Rulings issued a series of opinions that equity-linked notes are not taxable on an accrual basis but only on maturity, unless the taxpayer has the right to lock in the return before maturity and exercises that right. The mere fact that something could have been done to crystallize the value was not sufficient with other notes.

…The CRA never suggested that the possibility of locking-in the bonus means that an amount can be accrued based on the highest value of the index in the year. The mere possibility was not enough.

The Court concludes that the arguments put forth to justify the annual accrual of interest on the SLT Notes under Regulation 7000 represent a significant break from the prior practice of the CRA on equity-linked notes that cannot be justified by any distinction between the Notes and the prior equity-linked notes. Essentially, the CRA applied an assessing position to the SLT shareholders that it did not apply to any other taxpayer.

It also was unreasonable for CRA to assess all of the increase in value of the Note in the taxation years prior to 2005 (which were statute-barred) in its reassessments for the 2005 taxation year. Hamilton JCS stated (at para. 538):

It is difficult to understand how Regulation 7000(2)(d), which provides for the inclusion in income of “the maximum amount of interest thereon that could be payable thereunder in respect of that year” [emphasis added], can be interpreted in such a way as to include increases in value from previous years. The CRA made no attempt to explain this.

CRA made unreasonable reassessments with the knowledge that they were contrary to advice received from Rulings, offered in a settlement offer to settle elements that it knew it was going to abandon, failed to honour a commitment to give notice of the reassessments and delayed disclosures under the Access to Information Act process and made an inquiry with the Bermuda authorities that falsely stated that it was made in connection with a "criminal" investigation. 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 (i.e., 50% of the amounts) 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 damage to reputation (having regard to the false "criminal investigation" statement) and for stress, trouble and inconvenience. Hamilton JCS noted (at para. 732):

The professional fees, as well as investigation costs, wasted time and effort, photocopies, transcripts, travel, postage, etc., incurred in litigation or in preparing for litigation are not generally recoverable. They are considered not to be caused by the defendant’s fault that gave rise to the litigation but to be inconveniences inherent in litigation. ...

However, the professional fees and other costs incurred before the litigation and not in preparation for the litigation are recoverable to the extent that there is a sufficient causal link with the defendant’s fault.

Two of the taxpayers (“Ludmer” and Steinberg”) were invested along with family, friends and acquaintances (all resident in Canada) in a BVI company (“SLT”) whose investments were managed by a non-resident hedge fund manager (“GAM”). When GAM proposed that SLT be merged with another fund managed by GAM in which non-residents were investors, it was agreed that, in light of the merged fund being subject to a higher level of fees than those to which SLT had been subject, that a Bermuda company owned indirectly by two Steinberg and Ludmer non-resident trusts would receive annual “fees” from the time of the 1994 merger that effectively represented a rebate of the higher fees imposed on the Canadian investors (although they were described to be consideration for services that, in fact, were never provided). This arrangement was replaced in 2007 by a new agreement in which the “fees” were paid directly to two newly-established Canadian-resident family trusts.

In finding that it was not unreasonable for CRA to assess on the basis that these payments were includible in the income of Steinberg and Ludmer under s. 56(2), Hamilton JCS addressed the question whether such amounts would have been income form a source if they had been paid directly to such taxpayers stated (at paras. 614-615):

The GAM payments were not in the nature of a windfall. They were made pursuant to a contract. They were enforceable, organized, foreseeable and customary since 1995. …[T]he contracts provided for services to be provided as consideration for the payments. …

The argument put forward by Bowman that they are “nothings” for Canadian tax purposes because they are merely reputational payments arising in a non-business circumstance may ultimately be upheld by the Tax Court, but it is not so clear at this stage as to render the CRA’s position unreasonable.