On July 22, 2016, the Tax Court of Canada released its highly anticipated decision in Gerbro v. R1 dealing with the offshore investment fund property rules in section 94.1 of the Income Tax Act ("OIFP Rules"). The decision is helpful in clarifying the tax consequences for Canadians who invest, or are contemplating investing, in hedge funds located in low-tax jurisdictions. The hedge fund investments at issue in Gerbro were investments in offshore funds in which the investor or related persons held less than a 10% interest.

Gerbro Inc. ("Gerbro"), a holding company of a wealthy Canadian family, invested in three hedge funds (Raptor, Kingdon and Caxton) and two funds of funds (Hausmann and Arden) to complement its other investments. Gerbro's investment portfolio was well diversified and included fixed-income, segregated funds of long-equity and hedge funds. Its investment goals and strategy were determined in advance and were set out in detailed investment guidelines approved by its board of directors. The CRA assessed Gerbro for more than $1.5M of imputed income under the OIFP Rules for its 2005 and 2006 taxation years. The Tax Court of Canada allowed Gerbro's appeal and quashed the assessments, finding that Gerbro had an "overarching bona fide commercial reason for investing" in the funds.2

The OIFP Rules apply where a Canadian taxpayer invests in a non-resident entity (e.g., an offshore feeder of a hedge fund), which (i) primarily derives its value from portfolio investments in a broad list of assets mentioned in section 94.1 (the "Asset Test"), and (ii) where one of the main reasons for making the investment in the fund was to obtain a tax benefit (the "Motive Test"). A tax benefit includes deferral of Canadian income tax to the time when the shares in the fund are redeemed. Paragraphs 94.1(1)(c) to (e) list factors to be considered, such as the nature of the non-resident entity, the amount of tax paid by such entity and the amount of dividends the entity pays. The factors listed are not exhaustive. When the OIFP Rules apply, a Canadian investor will be required to pay taxes on a notional amount of 2% plus the prescribed rate of interest (currently 1%) applied to the adjusted cost of the investment, even if the fund does not distribute any income in the particular year, or is in a loss position.3 The imputed amount will be net of any actual income the investor receives from the fund (other than capital gains) and will be added to the cost of the investment, so as to limit double taxation of the same appreciation in value from year to year.

The Gerbro decision is a bearer of both good and bad news for Canadians investing or contemplating investing in hedge funds with offshore feeders.

The "Bad"

  • Hedge funds and funds of funds will generally derive their value primarily from "portfolio investments" for the purpose of the Asset Test. This is true even if fund managers actively manage their investment portfolio through sophisticated trading strategies. If a fund does not hold controlling interests in its investments (which is generally a stake of 10% to 25%) such investments will be characterized as portfolio investments. A portfolio investment is an investment in which a fund is not able to exercise significant control or influence, e.g. a routine investment in shares of a widely-held public company.
  • The Tax Court also rejected the argument that the OIFP Rules were merely a backstop to the foreign accrual property income (FAPI) regime, and concluded that portfolio investments could include inventory of an active investment business.
  • The Motive Test in section 94.1 is not a purely subjective test. A stated intention must be objectively reasonable in the circumstances and be corroborated with fact specific evidence.
  • Being unable to calculate the exact amount of tax savings from investing in a hedge fund located in a low-tax jurisdiction, in accordance with Gaynor v. R4, due to the lack of information about the fund's proprietary trades, does not defeat the Motive Test.

The "Good"

  • Credible business reasons for investing in offshore funds may defeat the Motive Test in certain circumstances, provided that the intention is objectively reasonable and supported by evidence. It is clear that it is insufficient for a Canadian investor to deny that the reason for investing in the offshore funds was to obtain a tax benefit.
  • Although an investor may have more than one main reason for investing, the more compelling a set of commercial reasons is, the harder it will be to get caught by the Motive Test. This is so, since tax reasons will only be considered to be ancillary in that case. On the other hand, the Motive Test will be met if the investor would not have invested in the offshore fund absent the tax benefit.
  • The reputation of a particular hedge fund manager, the manager's performance track record in achieving risk-adjusted returns and the manager's trading strategy (e.g., directional versus non-directional) may factor into an investor's commercial reasons for making an investment. These reasons may be relevant for purposes of the Motive Test.
  • The Tax Court appears to suggest that certain cash-settled derivatives would not be portfolio investments in listed assets for the purpose of the Asset Test.
  • In defending a potential assessment in the litigation process, the CRA cannot simply parrot the wording in section 94.1 in its assumptions of fact to "assume" that the Motive Test is met, as this is a question of mixed fact and law.
  • The Motive Test is generally indifferent to any transaction carried-out in the past in response to the now abandoned foreign investment entity (FIE) rules, since the considerations under these rules were entirely different.

Conclusion

The Gerbro decision provides some insight as to the relevant considerations in applying section 94.1, although there still remain some unanswered questions about all types of portfolio investments that are targeted.5 It is now clear that most hedge funds derive their value from portfolio investments for the purpose of the Asset Test. Accordingly, the OIFP Rules and more particularly the Motive Test must be carefully considered. Business reasons may overpower tax reasons for investing in offshore funds. Such reasons, however, are personal to each investor and must also be objectively reasonable in the circumstances. Clients are encouraged to seek legal advice in connection with this decision, to determine the legal ramifications for their particular circumstances.