International Tax Panorama

In a respite to Loblaw Companies Ltd. from $368 million in taxes, the Federal Court of Appeal overturned a 2018 ruling that found the company used a Barbados bank as a tax shelter.

The case dates back to the early 1990s. Loblaw was concerned about proposed tax changes negotiated under the Dutch-US Treaty and, to a lesser extent, the Canada-Dutch Treaty, which could negatively impact its financing subsidiary in the Netherlands. It chose to incorporate a new subsidiary called Loblaws Inc. in Barbados in 1992. A year later, it changed the name to Glenhuron Bank Limited (GBL), a subsidiary of Loblaw Financial Holdings Inc., and obtained a Barbadian banking license in 1993. The government argued the move was solely “to obtain tax benefits.” 

Moot Question

The moot question before the court was whether the foreign accrual property income (FAPI) provisions under the Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.) (ITA) is applicable to Loblaw Financial Holdings Inc. in relation to its Barbados subsidiary, Glenhuron Bank Limited. 

Minister’s contention

Loblaw Financial was required to pay tax on Glenhuron’s income on the basis that it was FAPI, in compliance with the reassessments issued by the Minister of National Revenue.  It was issued on the sole ground that Glenhuron’s income did not qualify for an exclusion provided to foreign banks under the FAPI. Thus, Loblaw Financial appealed from the reassessments to the Tax Court.

Earlier decision

In the earlier decision, the Tax Court gave the ruling in favour of the Minister by stating that foreign bank exclusion is not applicable. This is because Glenhuron conducted its business principally with non-arm’s length or affiliated corporations, instead with arm’s length entities as required under the FAPI. In this context it is important to look into the FPIA scheme and its relevance for foreign bank exclusion.

What is a FAPI Scheme

The FAPI scheme was brought in with the intention to prevent Canadians from avoiding tax on passive income, especially if they are earned via foreign entities located in low-tax jurisdictions. It requires the foreign entities’ passive income to be included under the Canadian shareholder’s income as it is earned.

However the scheme initially suffered from a major anomaly by not providing any legislative definitions of ” active busienss income” or “passive business income”. Even the government was concerned that the legislation did not have sufficient teeth to achieve its purpose. Accordingly, the legislation was overhauled in 1995 to provide detailed definitions. Here the passive income definition has been provided under the definition of “investment business”, under subsection 95(1) of the ITA.

Interpreting the meaning of “investment business”

The court looked into the definition of “investment business” under subsection 95(1) of the ITA, especially on the part of the definition that have specific exemptions for particular types of businesses, such as financial businesses which earn interest income in the context of an active business (paragraphs (a), (b) and (c)).

One of the conditions that must be fulfilled in order to qualify for one of the exemptions is an arm’s length requirement (paragraph (a) of the definition of “investment business”) This requirement is drafted as follows: “other than any business conducted principally with persons with whom the affiliate does not deal at arm’s length.” Thus, in order to be eligible for exemption from “investment business” the business must be “other than any business conducted principally with persons with whom the affiliate does not deal at arm’s length.

The court interpreted the term “investment business” under the ITA by considering the text, purpose and context of the legislation in a manner which is harmonious with the statute as a whole (Canada Trustco Mortgage Co. v. Canada, 2005 SCC 54 at para. 11, [2005] 2 S.C.R. 601). Harmonious interpretation was done to delineate whether Gelnhurin principally conducted business with arm’s length entities.

Who did Glenhurin “principally conducted business with”?

The first question to be determined in the appeal was: Who did Glenhuron principally conduct business with? Applying the plain meaning of the phrase “business conducted … with” the court suggested that it is applicable to every entity with whom Glenhuron has a business relationship, not limited to persons with whom Glenhuron had entered into income-earning transactions.

After finalising with whom Glenhuron conducted business, the weightage factor must be applied to every business relationships to determine the enitity with whom the corporation principally conducted its business. Here the use of the general term ““principally”” is suggestive of the weightage factor which must be applied to the present case.

What is Banking? 

The Court also looked into meaning of “banking”. By departing from the earlier decision the Court held that the term “banking” should be based on an institutional, formal approach than a substantive approach, in accordance with Canadian courts’ interpretations. Therefore, rather than considering the actual activities the foreign bank exemption must look into whether the corporation is regulated and licensed.

Competition element not required to invoke FAPI

The Court also couldn’t agree with the previous ruling on the element of Competition to invoke FAPI as the Parliament has not explicitly mentioned competition as an element of the foreign bank exclusion from FAPI. 

Shareholders and Corporation are separate entities

The Court held that the fundamental principle that a corporation and its shareholders are separate and distinct entities applies to the present case (see Chevron Corp. v. Yaiguaje, 2015 SCC 42 at para. 95, [2015] 3 S.C.R. 69). Thus, the previous decision that Gelnhuron works on behalf of Loblaws does not hold true.

Did Glenhuron conduct business principally with arm’s length persons?

The Court found out that Glenhuron principally conducted business with persons with whom it had contractual relationship with respect to swap transactions and short-term debt securities. Glenhuron dealt with all such persons on an arm’s length basis.

While applying the arm’s length test to these interactions, the court held that following factors must be considered: 

1. the impact on the arm’s length analysis through interaction with Loblaw Financial, 
2. determine the predominant income-earning transactions, and 
3. determine whether those transactions were conducted with persons with whom Glenhuron dealt at arm’s length.

However, the court held that this does not affect the ultimate issue of whether Glenhuron principally conducted business with arm’s length persons. The Court determined that Loblaws role was limited to support and oversight as a parent corporation over Gelnhuron. Also, the intent of the FAPI regime as a whole, and the foreign bank exclusion, in particular, was to encourage Canadians to carry on active businesses outside Canada. Here the Parliament could not have intended that the foreign bank exemption should be denied as a result of support and oversight provided by a parent corporation. The legislative intent would be frustrated if these interactions with Loblaw Financial were to be given significant weight.

As for weighing Glenhuron’s interactions in its income-earning transactions, a predominate weighting should be given to persons with whom Glenhuron dealt in the context of acquiring short-term debt securities and swaps. As clearly set out in the appended charts, the vast majority of Glenhuron’s assets were invested in US denominated short-term debt securities, cross-currency swaps, and interest rate swaps. These activities also generated the majority income. On the other hand the support activity of Loblaw was still small compared to the main business activity which involved the active participation of an investment team to purchase short-term debt securities and enter into swap transactions.

What is the meaning of business for FAPI purposes? 

The question presented by the Crown’s submission is whether funds received by Glenhuron for use in its business were part of the conduct of Glenhuron’s business for purposes of the definition of “investment business” in the ITA. For this purpose, the term “business” should be determined in accordance with Canadian law – not the law of Barbados.

For purposes of the ITA, the term “business” generally means ““something occupying the time and attention and labour of a man for the purpose of profit” (see Smith v. Anderson (1880), 15 Ch. D. 247 at 258 (C.A.) and the definition of “business” in subsection 248(1) of the ITA).

 The relevance of this issue is whether capital invested by the Loblaw group was part of the conduct of Glenhuron’s business. According to the court the capital investments by the Loblaw group were not part of Glenhuron’s conduct of business. Applying the meaning of “business,” there is no reason to conclude that the capital invested by the Loblaw group would have occupied the time and attention of Glenhuron in any meaningful way. Instead, the investments were part of Loblaw’s global strategy to transfer funds from other affiliates to Glenhuron to the extent that the funds were surplus to Loblaw’s business needs. It was a shareholder decision – and there is no reason to conclude that it involved business conducted by Glenhuron.

Thus the court concluded that Glenhuron’s FAPI is limited to its income in relation to investment management services provided to non-arm’s length persons. Thus the reassessments were send back to the Ministry. 

Award of costs

With respect to costs the court awarded costs to Loblaw Financial in a fixed amount of $1.8 million, plus reasonable disbursements.

Conclusion

The decision has major implications for entities who are operating their subsidiaries via low tax jurisdictions as a tax shelter strategy. The Court took a formal rather than a substance approach while interpreting banking operations. Even if Glenhuron was a subsidiary of Loblaw it didn’t conduct its principal activities with its parent corporation. The capital invested by Loblaw into Glenhurin did not occupy the time and attention of Glenhuron and thus it didn’t qualified for Glenhuron’s business. On the other hand the vast majority of Glenhuron’s assets were invested in US-denominated short-term debt securities, cross-currency swaps, and interest rate swaps, with whom it conducted its principal business. As these persons were at arm’s length the exemption to the FAPI regime is applicable to the present case.  Thus the decision is going to have major implications for entities who are operating their subsidiaries via low tax jurisdictions as a tax shelter strategy.