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Al Meghji of Osler, Hoskin & Harcourt LLP

SCC rejects Crown’s tax appeal in first ruling on ‘foreign accrual property income’ (FAPI) rules

Friday, December 03, 2021 @ 3:38 PM | By Cristin Schmitz

Last Updated: Tuesday, December 07, 2021 @ 3:20 PM


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Sending a reminder that the Crown should not expect judges to rewrite the Income Tax Act, the Supreme Court of Canada has ruled unanimously that Loblaw Financial Holdings Inc. is entitled to benefit from the “financial institution” exception in the “foreign accrual property income” (FAPI) tax rules with respect to income Loblaw received from a bank it owned in Barbados.

On Dec. 3, Justice Suzanne Côté dismissed 7-0 the appeal of the Minister of National Revenue from a decision below which held that the respondent Loblaw was not required to include the income of its now-defunct offshore commercial investment bank, Glenhuron, as FAPI because the taxpayer qualified for the “financial institution” exception under s. 95(1) of the Income Tax Act (ITA): Canada v. Loblaw Financial Holdings Inc., 2021 SCC 51.

The decision marks the first time the top court has considered the FAPI regime — described by Justice Côté as “one of the most complicated statutory regimes in Canadian law”, filled with “mindnumbing detail.”

The Supreme Court’s main determination was that Glenhuron’s investment banking business was conducted principally with persons it dealt with at arm’s length, thus meeting a key prerequisite for its earnings to be excepted from the FAPI rules, which require Canadian taxpayers to include in their Canadian tax returns, on an accrual basis, income earned by their controlled foreign affiliates.

As explained by Justice Côté, the dispute in the appeal came down to the meaning of the phrase “business conducted principally with” within the arm’s length requirement, and specifically whether providing corporate capital and exercising corporate oversight amount to conducting business with a foreign affiliate.

In other words, what type of activities did Parliament intend to be included in determining whether a business is conducted principally with non‑arm’s length persons. “The appeal boils down to what it means to conduct business — a narrow question of statutory interpretation,” said Justice Côté.

She emphasized at the outset that while “the tenor of the Crown’s submissions” was that Loblaw engaged in tax avoidance, in fact the Crown never raised any argument based on the ITA’s general anti-avoidance rule (GAAR), i.e. this was not a tax avoidance appeal.

“We are tasked only with interpreting the precise words of the arm’s length requirement — ‘the business (other than any business conducted principally with persons with whom the affiliate does not deal at arm’s length)’ — found in the financial institution exception, in accordance with the ordinary rules of statutory interpretation. When these words are read in their grammatical and ordinary sense, in harmony with their context and the ITA’s objects, it becomes clear that they do not encompass an assessment of capital contributions or corporate oversight,” she held, rejecting the Crown’s arguments.

She concluded, “if capital and corporate oversight are excluded from consideration, the vast majority of business was conducted between Loblaw Financial’s foreign affiliate and persons with whom it was dealing at arm’s length. Therefore, Loblaw Financial can avail itself of the financial institution exception. Given the text, context and purpose of the provision at issue, there is no reason for a court to deny Loblaw Financial the ability to arrange its affairs so as to minimize its tax payable,” she said, quoting the decades’ old Duke of Westminster principle that “every man is entitled, if he can, to order his affairs so as that the tax attaching under the appropriate Acts is less than it otherwise would be. If he succeeds in ordering them so as to secure this result, then, however unappreciative the Commissioners of Inland Revenue or his fellow taxpayers may be of his ingenuity, he cannot be compelled to pay an increased tax.”  

The stakes of the Loblaw appeal were high for the respondent taxpayer: If the Crown prevailed, Loblaw would have been on the hook to pay tax on close to half a billion dollars in earnings the Crown deemed to be FAPI, that Loblaw had received from 2001 to 2010 from its foreign subsidiary. (Glenhuron was dissolved in 2013.)

The court’s answer to the specific legal question in the appeal — i.e. that the “financial institution” exception to the foreign accrual property income rules does apply to the offshore bank in question — is important as well to many other Canadian financial institutions with international operations — as an intervention by the Canadian Bankers’ Association made clear.

For its part, the federal Crown urged in its leave application to the top court that the Federal Court of Appeal’s decision below “has imperiled the collection of approximately $1.181 billion in tax, so far, by failing to properly articulate the antiavoidance purpose that permeates this regime, by characterizing the regime as incentivizing offshore investment, and by mandating a restrictive interpretation to lower courts tasked with considering these rules. These are issues of public importance.”

Certainly the overall approach the court takes to interpreting the FAPI rules is significant, not just for financial institutions, but for all kinds of Canadian business with multinational operations.

Al Meghji, Osler, Hoskin & Harcourt LLP

The court’s multilayered judgment, which respects that it is Parliament’s role to enact tax policy in legislation, and the court’s role to interpret that legislation, is important for all Canadians, suggested Loblaw’s lead counsel, Al Meghji of Osler, Hoskin & Harcourt LLP in Toronto.

“It says to taxpayers and people who engage in commercial transactions that the Supreme Court of Canada values commercial certainty; that they can be rest assured that the Supreme Court of Canada still thinks having certainty in tax legislation is a public policy imperative.”

Meghji, who has argued a dozen tax cases in the top court, sees the main takeaway from the judgment as “that the Income Tax Act is a statute which is very detailed, and Parliament largely expresses its view in the text of the statute, and that courts and taxpayers should read the words of the statute dispassionately, and apply what the legislation says, and not infuse it with vague notions of purpose and hyperbole.”

Meghji, whose co-counsel was Pooja Mihailovich, said the Federal Court of Appeal sent out a similar message in another recent tax decision: Canada v. Cameco Corp. 2020 FCA 112 (The Supreme Court denied leave to appeal in that case, which Meghji also won.)

“These are two statutory interpretation cases, and instead of simply applying the terms of the statute, the Crown essentially attempted to argue broad policy points, and paid little regard to what the actual legislation said,” Meghji asserted. “And in both cases, the court said ‘No, we’re going to apply the legislation as it speaks.’ So I see the trend as being that the Crown doesn’t pay sufficient attention to the statutory text, and the trend is for the courts to say: ‘That’s not the way we run the tax system.’ ”

Together with last week’s Supreme Court of Canada decision interpreting the ITA’s general anti-avoidance rule (GAAR), Meghji said the court’s message is, even when the GAAR applies, judges are not going to “make stuff up” or engage in “judicial gerrymandering. ‘We’re going to apply a disciplined approach to interpreting and applying taxation statutes.’ ”

He said it is “very gratifying” that all seven Supreme Court judges, as well as a three-judge panel of the Federal Court of Appeal, agreed that Loblaw abided by the ITA.

In a prepared statement from the Canada Revenue Agency (CRA) e-mailed to The Lawyer’s Daily, the agency said “while disappointed, the CRA respects the decision of the Supreme Court of Canada and the process that led up to this. The CRA will review the decision with the Department of Finance and Department of Justice.”

The CRA noted that the issue in the appeal “was important to our ongoing efforts to protect Canada’s tax base. The full impact of the decision will be explored to ensure integrity of tax administration around our efforts to combat international tax avoidance. The foreign accrual property regime in the Income Tax Act should not give taxpayers an incentive to place their assets offshore to earn income free of Canadian tax.”

The CRA added that the agency “remains committed to combating international tax avoidance, which erodes Canada’s tax base and undermines the government’s ability to provide benefits and services to Canadians. The CRA will continue to apply the Income Tax Act to ensure taxpayers pay their fair share.”

University of Ottawa tax law professor Vern Krishna called the Supreme Court’s latest tax ruling “a textbook analysis of interpretation that tax practitioners and planners should keep close at hand: [the message is] determine the intent of Parliament by examining the text of the ITA in its entire context, and in its grammatical and ordinary sense, alongside the statute’s scheme and objects.”

Krishna, who is of counsel at Tax Chambers LLP in Toronto, said that “absent any expressed legislative intent, the court rejects the Crown’s unsupported allegation that the purpose of the arm’s length requirement in the Income Tax Act was to create a specific anti-avoidance rule.”

“The Supreme Court reiterates that if taxpayers are to act with any degree of certainty, then the CRA should give full effect to Parliament’s precise and unequivocal words,” he added.

Krishna predicted that in light of the “billions of dollars” that turn on the court’s interpretation of the ITA provision at issue, “the Department of Finance will most likely draft even more ‘mind-numbing detail’ in the FAPI rules to introduce anti-avoidance rules — which should take another decade to resolve.”

Loblaw incorporated a subsidiary in 1992 that was licensed by Barbados to operate as an offshore bank. Over the years, Loblaw Financial and affiliated companies made significant capital investments in Glenhuron. However, in 2013, Glenhuron was dissolved, and its assets were liquidated.

For the 2001, 2002, 2003, 2004, 2005, 2008 and 2010 taxation years, Loblaw Financial did not include income earned by Glenhuron in its Canadian tax returns as FAPI.

Under the ITA’s FAPI regime, Canadian taxpayers must include income earned by their controlled foreign affiliates (CFAs) in their Canadian annual tax returns on an accrual basis if this income qualifies as FAPI. However, financial institutions that meet four requirements may benefit from an exception to the FAPI rules found in the definition of “investment business” in s. 95(1) of the ITA.

The financial institution exception applies when: (1) the CFA is a foreign bank or another financial institution listed in the exception provision; (2) its activities are regulated under foreign law; (3) the CFA employs more than five full‑time employees in the active conduct of its business; and (4) its “business must be conducted principally” with persons with whom it deals at arm’s length.

Loblaw Financial claimed that Glenhuron’s activities were covered by the financial institution exception to the FAPI rules, but the Minister of National Revenue reassessed on the basis that the income earned by Glenhuron was FAPI. The Crown contended that the fourth requirement was not met. Loblaw Financial objected and appealed the reassessments.

The Tax Court rejected Loblaw’s appeal on the basis that the financial institution exception did not apply, as Glenhuron’s business was conducted principally with non‑arm’s length persons (i.e. Loblaw Group).

In making its determination, the Tax Court considered the scope of Glenhuron’s relevant business, looking at the investment bank’s receipt of funds and use of funds. The Tax Court included in its analysis all funds the bank received, treating capital injections by shareholders and lenders like any other receipt of funds. The Tax Court also viewed Glenhuron’s use of funds as the management of an investment portfolio on the Loblaw Group’s behalf, and regarded the influence of the Loblaw Group’s central management as pervading the conduct of business because of the Loblaw Group’s close oversight of Glenhuron’s investment activities.

The Federal Court of Appeal reversed, disagreeing both with the Tax Court’s interpretation of the arm’s length requirement and with the lower court’s analysis based on Glenhuron’s receipt and use of funds.

A three-judge appeal panel held that only Glenhuron’s income‑earning activities had to be considered under the ITA. The panel also found that direction, support and oversight by the Loblaw Group should not have been considered, because these interactions are not income‑earning activities and thus do not amount to conducting business with the controlled foreign affiliate.

The Federal Court of Appeal accordingly held that Glenhuron was dealing principally with arm’s length persons, and that Loblaw Financial was entitled to the benefit of the financial institution exception and did not need to include Glenhuron’s income as FAPI. It referred the minister’s reassessments back for reconsideration.

In affirming that result, Justice Côté held that “the grammatical and ordinary meaning of the words ‘business conducted’, read in the context and light of the purpose of the FAPI regime, clearly shows that Parliament did not intend capital injections to be considered.”

Thus, “once corporate oversight and the capital investments received by Glenhuron are excluded, only Glenhuron’s investment activities remain part of the business that is relevant for the application of the arm’s length requirement,” she said. “The most lucrative of those activities undertaken by Glenhuron were conducted at arm’s length, amounting to at least 86 percent of its income during the years in issue. On the non‑arm’s length, Glenhuron’s combined activities do not reach the ‘principally’ threshold,” Justice Côté reasoned. “The arm’s length requirement was therefore met during the years in issue.”

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