Although based in low-tax jurisdictions, Tax Court finds business reasons for investments overshadowed their tax benefits
Section 94.1 of the Income Tax Act (Canada) is an anti-avoidance rule aimed at attempts to divert investment income to an offshore entity in a low (or no) tax jurisdiction. In Gerbro Holdings Company v. The Queen , the Tax Court of Canada considered, for the first time, the application of this rule to investments in offshore hedge funds.The Court concluded that the underlying assets of such funds may be “portfolio investments” for purposes of section 94.1, but the section did not apply in Gerbro because none of the main reasons for investing in the hedge funds was to defer or avoid Canadian taxes.
Section 94.1 requires a deemed income inclusion where a Canadian investor has an interest in a non-resident entity, and two conditions are met:
- the interest in the entity derives its value primarily from “portfolio investments” in specified properties (including shares, debt, commodities, real estate and currencies) (the Value Test) and
- it may reasonably be considered that one of the main reasons for investing in the entity is to significantly reduce the taxes that would have been applicable if the income from such investments had been earned directly (the Motive Test).
Section 94.1 was introduced in 1984 in response to the marketing of offshore mutual funds as vehicles to earn passive income tax-free.Although successful in shutting down the “interest roll-up” funds it targeted, section 94.1 was criticized for its arbitrary income inclusion, uncertainty surrounding the term “portfolio investments,” and (by the tax authorities) for the challenges of establishing that an investment is tax-motivated. Nearly 10 years of proposals to amend section 94.1 (and recast it as a capital export neutrality measure, applicable to any low-tax jurisdiction investment) were abandoned in 2010 as too complex; instead, the amount of the deemed income inclusion was increased and, except for changes to its administration (reassessment period, reporting obligations), section 94.1, with its unresolved issues, remains otherwise unchanged.
The Gerbro hedge fund investments
Gerbro Holdings Company was a holding company responsible for investing the assets of its sole shareholder, a Canadian spousal trust, during the beneficiary’s lifetime. In 2005, Gerbro began adding investments in five large offshore hedge funds to its more traditional holdings. The hedge funds were located in low-tax jurisdictions, had high profile, reputable fund managers, and followed active and sophisticated trading strategies in a range of instruments including securities, options, commodity futures, foreign currencies and, to some extent, cash-settled derivatives such as contracts for differences; they generally reinvested their earnings.
To determine if section 94.1 applied to Gerbro’s investments in these funds, the Tax Court had to consider both the portfolio investment “Value Test” and the taxpayer “Motive Test”.
“Value Test” / “portfolio investments”: control is determinative; can include inventory of an active business
The term “portfolio investments” is not defined in the Income Tax Act. Based on financial and accounting definitions of the term, the Court concluded that a portfolio investment is “an investment in which the investor (non-resident entity) is not able to exercise significant control or influence over the property invested in.” Significantly for hedge fund investments, the emphasis on control led the Court to also conclude that “the term portfolio investment can include inventory of an active investment business since actively trading in such inventory does not turn a non-controlling interest into a controlling one.”
Applying the significant control definition to the hedge funds Gerbro invested in, the Court found they did derive their value primarily (more than 50%) from portfolio investments: the funds did not take controlling interests in any entities, investing instead in publicly traded securities or commodities with a view to capital appreciation. The application of section 94.1 therefore turned on the Motive Test.
“One of the main reasons” is a tax benefit: not purely subjective, but a factual determination; reasons should be objectively reasonable
Section 94.1 requires that a significant reduction or deferral of tax be “one of the main reasons” for acquiring or holding the interest in the non-resident entity.
This test, the Court said is not purely subjective, but it is a factual determination intrinsically linked to the evidence provided at trial. The stated reasons for the investment must be objectively reasonable taking into account the surrounding circumstances, including those set out in section 94.1 (the nature, organization and operation of the non-resident entity, the amount of any tax benefit and the extent of distributions). The Court set out five principles relevant to this factual determination:
- A taxpayer's reasons for investing can be disclosed or undisclosed, and the fact that a tax-avoidance reason is undisclosed, as is often the case, does not prevent a court from inferring that such a reason existed.
- There can be more than one main reason for investing in a non-resident entity.
- The Motive Test is not a sine qua non test under which the Court must conclude that tax avoidance was not a main reason for investing if it is convinced that the taxpayer would have invested notwithstanding the absence of any tax benefit.
- It is improper to conclude that resulting tax savings automatically lead to the inference that obtaining those tax savings must have been a main reason for investing.
- Choosing to invest in a non-resident entity when there was the possibility of investing in another vehicle triggering a larger tax liability is not necessarily determinative of a tax benefit main reason.
The Court found that the tax deferral benefit was one of the reasons, conscious or not, for Gerbro’s hedge fund investments, but it was not a main reason, and was less important than Gerbro’s commercial reasons for investing. The evidence showed that Gerbro invested to obtain good returns, reduce the overall volatility of its portfolio, invest with trustworthy individuals and hold liquid investments. Reducing volatility was especially important because the trust’s beneficiary was aging and it was possible the investments would have to be liquidated on short notice.
The Court acknowledged that drawing a line between main and secondary reasons is difficult, and suggested that the more important one reason is, the harder it may be to elevate another. This was relevant in the Gerbro case, because of the importance of the funds for Gerbro’s overall investment strategy, particularly for reducing volatility. The nature, organization and operation of the funds all operated in Gerbro’s favour: the hedge funds were very attractive investments for non-tax reasons; Gerbro did not hold large interests in the funds, played no role in their structuring, and had no control over them; Gerbro could not access their managers services, nor invest in their underlying assets, directly.
In the case of offshore hedge fund investments, the reasoning in Gerbro focuses the section 94.1 analysis on the investor’s motives.
It is noteworthy, therefore that Gerbro confirms that the presence of tax savings alone is not sufficient to trigger the application of the section. The decision also allows that a tax reason may be a secondary reason for an investment. In this respect, the decision recognizes that the motivation for investments in offshore hedge funds can be better yields, more attractive asset mixes that could not be obtained directly, and access to the specialized expertise and market knowledge of particular fund managers.
Taxpayers must also note, however, that the determination of motive is a factual one. Gerbro benefited not only from particularly favourable facts, but also from long-standing and well-documented investment guidelines that evidenced the considerations guiding its investment decisions. Taxpayers making investments in offshore funds will be well-advised to fully document the considerations behind their investment decision.