The Tax Court of Canada (the "TCC") recently considered in Lehigh Cement Ltd. v. R. (2013 TCC 176) (“Lehigh Cement”) the application of the anti-avoidance rule in paragraph 95(6)(b) of the Income Tax Act (Canada) (the “Act”) in the context of the acquisition of shares of a foreign affiliate (“FA”). This anti-avoidance rule generally provides that, where it can reasonably be considered that the principal purpose of an acquisition or disposition of shares of a corporation, is to permit a person to avoid, reduce or defer the payment of tax or any amount that would otherwise be payable under the Act, such acquisition or disposition is deemed not to have occurred.
Thus, the anti-avoidance rule at issue in Lehigh Cement may, where it applies, prevent a Canadian resident taxpayer from taking advantage of the beneficial aspects of the FA regime in respect of an acquisition of shares of a non-resident corporation. Alternatively, it may prevent a Canadian resident taxpayer from avoiding the negative aspects of having a non-resident corporation treated as a "controlled foreign affiliate" (“CFA”) by effecting a disposition of shares of a non-resident corporation.
Canadian Foreign Affiliate Regime
Canadian resident taxpayers owning shares of non-resident corporations are subject to special rules under the Act relating to, among other things, income earned by, and distributions received from, such corporations. The application of these rules depends in part on the degree of ownership that the Canadian resident taxpayer has in the non-resident corporation and in part on the type of income earned by the non-resident corporation. An FA of a Canadian resident taxpayer generally means a non-resident corporation in which the Canadian resident taxpayer's direct or indirect ownership interest in any class of shares of the non-resident corporation is at least 1% and the total direct or indirect ownership interest of the Canadian resident taxpayer and related persons in any class of shares of the non-resident corporation is at least 10%.
Treatment of a non-resident corporation as an FA can result in certain advantages to a Canadian resident taxpayer. One such advantage is that dividends received by Canadian resident corporations from FAs that are paid out of the "exempt surplus" of an FA can generally be deducted in computing the income of the Canadian resident corporation under paragraph 113(1)(a) of the Act . The exempt surplus of an FA generally includes earnings from an active business carried on by an FA in a country or jurisdiction that has a comprehensive tax treaty or tax information exchange agreement with Canada.
However, treatment of a non-resident corporation as a CFA can result in certain disadvantages to a Canadian resident taxpayer. A CFA generally means an FA that is controlled or would be controlled by the Canadian resident taxpayer if the Canadian resident taxpayer owned the shares of certain other persons (including non-arm's length persons). For purposes of the CFA definition, control means de jure control. The primary disadvantage of having a CFA is that certain passive income earned by the CFA is treated as foreign accrual property income (“FAPI”) and included in the Canadian resident taxpayer's income on an accrual basis even if such income is not distributed to the Canadian resident taxpayer.
Passive income earned by an FA may be treated as active business income for purposes of computing the exempt surplus of an FA if certain conditions are met. For the taxation years under review in Lehigh Cement, passive income (including interest income) received by an FA of a Canadian resident taxpayer was treated as active business income of the FA, provided that such income was paid or payable to the FA by another non-resident corporation that was related to both the FA and the Canadian resident taxpayer, and that such amounts were deductible by the other non-resident corporation in computing its earnings or loss for a taxation year from an active business, other than an active business carried on in Canada.
The taxpayers in Lehigh Cement were members of a foreign-controlled international corporate group. One of the taxpayers, "CBR Canada", was a Canadian cement and related products manufacturer and retailer. The other taxpayer, "CBR Alberta", was a wholly-owned subsidiary of CBR Canada. "CBR US", a sister corporation of CBR Canada, was a cement and related products manufacturer and retailer in the United States.
Between 1987 and 1991, CBR US made a series of acquisitions. Starting in 1991, CBR US started to incur operating losses. In order to finance these acquisitions and losses, CBR US borrowed $44.3 million (all figures in U.S. dollars) from the Belgium-resident parent corporation of the corporate group and $14 million from a wholly-owned Luxembourg subsidiary of the Belgian parent. CBR US also received a $40 million capital contribution from its U.S. parent which had been raised by a sale of preferred shares to CBR Canada.
In 1995, the corporate group decided to refinance the debt and equity of CBR US. CBR Canada and CBR Alberta formed a Delaware LLC ("NAM LLC"), which was structured as an FA of both CBR Canada and CBR Alberta. CBR Canada held a 99 % interest in NAM LLC and CBR Alberta held the remaining 1% interest. CBR Canada then borrowed $60 million from a third party lender at an interest rate of 6.7%. CBR Canada used $600,000 of the borrowed funds to subscribe for preferred shares of CBR Alberta, and then CBR Canada and CBR Alberta both made contributions to NAM LLC in the aggregate amount of $60 million.
NAM LLC loaned the $60 million to CBR US at an interest rate of 8.25%, and these funds were used by CBR US to repay the intercompany borrowings described above. A similar series of transactions was undertaken later in 1995 to refinance the $40 million capital contribution to CBR US described above whereby NAM LLC loaned an additional $40 million to CBR US. As of December 31, 1995, NAM LLC had loaned $100 million to CBR US, using funds contributed by CBR Canada ($99 million) and CBR Alberta ($1 million).
The expectation under the new financing structure was that it would result in tax savings of approximately $1.92 million per year for CBR Canada and approximately $1.19 million per year for the Belgian parent. The tax savings in Canada resulted from the deduction claimed by CBR Canada for interest paid (at the rate of 6.7% on the $60 million loan and 6.84% on the $40 million loan) on the $100 million borrowed by CBR Canada to purchase the shares of NAM LLC and CBR Alberta and the deduction claimed by CBR Canada and CBR Alberta for dividends paid by NAM LLC to CBR Canada and CBR Alberta out of its exempt surplus.
After operating under this financing structure in 1996 and most of 1997, the structure was changed in late 1997 largely as a result of a change in Belgian tax law. NAM LLC was dissolved, and the financing was restructured as an investment of $100 million by CBR Canada in CBR Alberta which in turn used the funds to invest in preferred shares of CBR US. As such, the appeal concerned the 1996 and 1997 taxation years.
The Minister of National Revenue (the “Minister”) relied on the anti-avoidance rule in paragraph 95(6)(b) to deny the deduction for dividends received by the Canadian resident taxpayers from NAM LLC on the basis that the Canadian resident taxpayers had acquired shares of NAM LLC in circumstances where it could reasonably be considered that the principal purpose for the acquisition of the NAM LLC shares was to permit the Canadian resident taxpayers to avoid, reduce or defer the payment of tax under the Act. The Minister applied the anti-avoidance rule in paragraph 95(6)(b) to deem the Canadian resident taxpayers not to have acquired shares of NAM LLC for the purposes of determining if NAM LLC was an FA with the result that the deduction for dividends paid out of an FA's exempt surplus under paragraph 113(1)(a) of the Act was therefore not available. The Canadian resident taxpayers appealed the Minister’s decision to the TCC.
TCC Analysis and Decision
The issue before the TCC in Lehigh Cement was whether the anti-avoidance rule in paragraph 95(6)(b) applied to the acquisition of shares of NAM LLC by CBR Canada and CBR Alberta. The parties agreed that, if the TCC were to find that this anti-avoidance rule was applicable, the shares of NAM LLC would be deemed not to have been acquired by CBR Canada and CBR Alberta with the result that the tax benefits derived by CBR Canada and CBR Alberta from the deduction of dividends paid out of exempt surplus under paragraph 113(1)(a) of the Act would be denied.
The anti-avoidance rule in paragraph 95(6)(b) of the Act read as follows for the taxation years under review: “where a person or partnership acquires or disposes of shares of the capital stock of a corporation, either directly or indirectly, and it can reasonably be considered that the principal purpose for the acquisition or disposition of the shares is to permit a person to avoid, reduce or defer the payment of tax or any other amount that would otherwise be payable under this Act, those shares shall be deemed not to have been acquired or disposed of, as the case may be, and where the shares were unissued by the corporation immediately prior to the acquisition, those shares shall be deemed not to have been issued.”
The taxpayers argued in this case that, based on a textual, contextual and purposive reading of paragraph 95(6)(b), the application of this anti-avoidance rule should be limited to situations where an acquisition or disposition of shares of an FA is carried out to manipulate the status as an FA and the purpose of the share acquisition or disposition in and of itself (not the purpose of the series of transactions of which the acquisition or disposition may form part) is to avoid tax.
The taxpayers conceded that the main benefits from the implementation of the refinancing transactions were to improve tax efficiency. However, the taxpayers argued that the principal purpose of the acquisition of shares of NAM LLC was not to avoid Canadian taxes since CBR Canada could have claimed an interest deduction under paragraph 20(1)(c) of the Act and a dividend deduction under paragraph 113(1)(a) of the Act by investing directly in the shares of CBR US. Furthermore, the taxpayers argued that the purpose of the NAM LLC share acquisition was to permit CBR US to claim an interest deduction in computing its U.S. income taxes and that such a purpose should not be relevant to the application of paragraph 95(6)(b).
The TCC analyzed the anti-avoidance rule in paragraph 95(6)(b) using a textual, contextual and purposive approach. After reviewing the text of the provision, the TCC agreed with the taxpayers that it was only the purpose of the acquisition or disposition of shares in and of itself that was material in determining whether the anti-avoidance rule applies. However, the TCC held that even where a provision does not specifically refer to the purpose of a "series of transactions", the overall purpose of such series may be a relevant factor in determining the purpose of a specific transaction within the series. Accordingly, the TCC was free to consider the overall tax-reduction “purpose” of the entire refinancing transactions when determining the principal purpose of the acquisition of shares of NAM LLC by the Canadian taxpayers.
The taxpayers argued that the context of the anti-avoidance rule in paragraph 95(6)(b) showed that it is only intended to preclude acquisitions or dispositions of shares by a taxpayer that are designed to put such taxpayer in technical compliance with the share ownership requirements for FAs (or to avoid having CFA treatment) in circumstances where such ownership is not reflective of "the true economic ownership of shares" of the non-resident corporation at issue.
The TCC rejected this approach, holding that the text of the anti-avoidance rule in paragraph 95(6)(b) was clear and that a textual, contextual and purposive analysis of the anti-avoidance rule showed that this anti-avoidance rule was broad enough to encompass any share acquisition or disposition which is principally tax-motivated. Unlike with the application of the general anti-avoidance rule in section 245 of the Act, there was no requirement under paragraph 95(6)(b) that there be a misuse or abuse of the FA provisions in order for the anti-avoidance rule to apply.
Despite rejecting many of the taxpayers' arguments as to the general interpretation and scope of the anti-avoidance rule in paragraph 95(6)(b), the TCC held that this rule did not apply in the circumstances of this case. The TCC identified three stages of inquiry in determining whether the rule applies: (1) identify the tax otherwise payable under the Act that the taxpayers were alleged to have intended to avoid; (2) determine whether the acquisition of shares permitted the tax avoidance, reduction or deferral; and (3) assess whether tax avoidance was the principal purpose of the acquisition of the shares.
The key to the decision was the TCC's interpretation of the first stage of the analysis. In the TCC’s view, the inclusion of the words "tax otherwise payable" in the rule implied that it was not enough that there be a "tax benefit" resulting from the transactions (e.g., in the form of a deduction claimed under the Act such as a deduction of dividends received from an FA). Instead, the analysis of "tax otherwise payable" requires a comparison with an alternative situation that may reasonably have been carried out by the taxpayers, and the relevant comparator is "an arrangement where the acquisition or disposition has not occurred".
The TCC accepted the taxpayers' argument that a reasonable alternative arrangement in the circumstances would have been for CBR Canada to directly subscribe for shares in CBR US using borrowed funds, rather than subscribing for shares in NAM LLC. This was in substance the arrangement that existed after the financing structure was changed again in late 1997. Under that scenario, the Canadian tax results would have been the same as the Canadian tax results for the taxation years under review. Accordingly, the TCC held that there was no Canadian tax "otherwise payable" that was avoided by the acquisition of shares in NAM LLC, and the anti-avoidance rule did not apply on the facts. In arriving at its decision, the TCC confirmed that the U.S. tax benefits derived from the refinancing transactions were not relevant. The taxpayers' appeals were allowed.
Although the taxpayers were successful in this case, the TCC took a broad interpretation of the anti-avoidance rule in paragraph 95(6)(b) of the Act. Of particular concern is the holding that the anti-avoidance rule is broad enough to encompass "any acquisition or disposition of shares that is principally tax-motivated" and that the overall purpose of the “series of transactions” must be considered in making such a determination. Despite the Minister’s loss in Lehigh Cement, it will be interesting to see whether the Minister will increase its reliance on paragraph 95(6)(b) of the Act to attempt to deny FA status in the context of financing and other arrangements involving acquisitions and dispositions of shares of non-resident corporations by Canadian resident taxpayers.