The Federal Court of Appeal recently issued its decision1 in a case that considered the scope of a specific anti-avoidance rule in paragraph 95(6)(b) of the Income Tax Act(Canada) (Tax Act).
Paragraph 95(6)(b) appears in subdivision i of the Tax Act that deals with the tax consequences associated with the ownership of shares in a non-resident corporation and, where paragraph 95(6)(b) applies, a taxpayer can be deemed for purposes of subdivision i to have not acquired or disposed of shares the taxpayer had otherwise acquired or disposed of in the non-resident corporation.
The transactions that were the subject of the tax appeal took place almost 20 years ago and the favourable Canadian tax consequences that the taxpayer sought to achieve through the particular series of transactions are only of historical significance today as a result of amendments subsequently made to provisions of the Tax Act other than paragraph 95(6)(b). However, the case is an important one because it considers whether the anti-avoidance rule in paragraph 95(6)(b) has the broad scope that the Canada Revenue Agency (CRA) has asserted and applied to a broad range of transactions since the early 2000s (based on the wording of the provision) or the narrow scope asserted by taxpayers (based on the statutory context in which the provision appears).
At trial, the Minister persuaded the Tax Court of Canada to accept the CRA’s broader interpretation of the scope of paragraph 95(6)(b) but the taxpayers were ultimately successful in having the reassessments set aside because the Tax Court found that the factual pre-conditions for having the provision apply did not exist.
The Minister appealed the Tax Court decision and, as discussed in greater detail below, the Federal Court of Appeal not only upheld the Tax Court’s decision but, in so doing, also rejected the Minister’s broad interpretation of the scope of paragraph 95(6)(b).
Lehigh Cement Limited (Lehigh), is a Canadian company that manufactures cement and building products. It was a member in a multi-national group of companies (CBR Group) whose ultimate parent company was a Belgian company, CBR SA.
During the period relevant to the appeal, Lehigh had a U.S.-resident sister corporation, CBR Cement Corporation (CBR US). Before undertaking the transactions that were the subject of this appeal, CBR US’s capital structure consisted of debt of approximately $58 million owed to CBR SA and a CBR SA Luxembourg subsidiary (CBR AM) and $40 million of capital contributions by its U.S. parent corporation, CBR Investment Corporation of America (CBR ICA), which CBR ICA funded by issuing preferred shares to Lehigh.
In two separate series of transactions taking place during 1995, the CBR Group reorganized the capital structure of CBR US though transactions that involved (i) Lehigh, (ii) CBR Alberta Limited (CBR Alta), a newly-formed wholly-owned Canadian Lehigh subsidiary, and (iii) CBR Developments NAM LLC (NAM LLC), a newly formed U.S. limited liability company in which Lehigh and CBR Alta were the sole members.
In the first series of transactions, Lehigh borrowed $60 million from Citibank Canada Inc. at an annual interest rate of 6.7% and contributed the entire proceeds (either directly itself or indirectly through CBR Alta) to the equity in NAM LLC. NAM LLC used the equity contribution to make a loan to CBR US that bore interest at an annual rate of 8.25% and, in turn, CBR US used the borrowing to repay its loans from CBR SA and CBR AM.
In the second series of transactions, Lehigh borrowed $40 million from Brussels Bank Lambert at an annual interest rate of 6.84% or a floating rate, depending on the circumstances. Lehigh contributed the entire $40 million proceeds (either directly itself or indirectly through CBR Alta) to the equity in NAM LLC. NAM LLC used the equity contribution to make a $40 million loan to CBR US that bore interest at an annual rate of 8.25%. CBR US used the loan proceeds to pay a $40 million dividend to CBR ICA which CBR ICA used to redeem the preferred shares that CBR ICA had issued to Lehigh.
The principal Canadian tax consequences that the CBR Group companies anticipated from these two series of transactions were the following:
- Lehigh would be able to deduct the interest expense incurred on the loans from Citibank Canada and Brussels Bank Lambert (used to fund Lehigh’s direct and indirect equity investment in NAM LLC) in computing its income for purposes of the Tax Act.
- Subparagraph 95(2)(a)(ii) of the Tax Act (as it then read) would apply to interest income that Lehigh’s and CBR Alta’s foreign affiliate NAM LLC earned on its loans to CBR US and deem such income to be active business income of NAM LLC. Dividends paid to Lehigh and CBR Alta derived from such income would be received as tax-free dividends paid out of NAM LLC’s exempt surplus (i.e., includable in income but eligible for an offsetting deduction pursuant to paragraph 113(1)(a) of the Tax Act).
The Minister’s Reassessments
In the reassessments under appeal, the Minister relied on paragraph 95(6)(b) as a statutory basis for disallowing the paragraph 113(1)(a) deductions that Lehigh and CBR Alta claimed in connection with the dividends that they received from NAM LLC.
Paragraph 95(6)(b) provides, as follows:
(6) For purposes of this subdivision (other than section 90), ….
(b) where a person or partnership acquires or disposes of the capital stock of a corporation or interests in a partnership, either directly or indirectly, and it can reasonably be considered that the principal purpose for the acquisition or disposition is to permit a person to avoid, reduce or defer payment of tax or any other amount that would otherwise be payable under this Act, that acquisition or disposition is deemed not to have taken place, and where the shares or partnership interests were unissued by the corporation or partnership immediately before the acquisition, those shares or partnership interests, as the case may be, are deemed not to have been issued.
The Minister reasoned that, if paragraph 95(6)(b) applied to deem Lehigh’s and CBR Alta’s acquisition of equity in NAM LLC to have not taken place, NAM LLC could not qualify as a foreign affiliate of Lehigh or CBR Alta for purposes of the Act and, therefore, Lehigh and CBR Alta were not entitled to claim the paragraph 113(1)(a) deduction for dividends received from a foreign affiliate of the taxpayer. (Section 90 of the Tax Act requires dividends received on shares of a non-resident corporation to be included in income even where paragraph 95(6)(b) deems the dividend-paying shares to not have been issued to the dividend recipient.)
For paragraph 95(6)(b) to apply to the acquisition of capital stock of a corporation, the principal purpose of the acquisition must be to permit a person to avoid, reduce or defer payment of tax or any other amount that would otherwise be payable under the Act. In applying paragraph 95(6)(b) in Lehigh’s and CBR Alta’s circumstances, the Minister situated the examination of the acquisition of equity in NAM LLC in the context of the overall refinancing of CBR US. The Minister’s view was that the "principal purpose" test in paragraph 95(6)(b) was satisfied because the principal purpose of the overall refinancing was to achieve the "tax asymmetry" of having the deduction under the Tax Act for the interest expense on the funds borrowed for the investment in NAM LLC but no income inclusion under the Tax Act for the dividend payments from NAM LLC.
Tax Court of Canada
The main legal argument the taxpayers advanced in the Tax Court was that paragraph 95(6)(b) was enacted to prevent Canadian taxpayers from manipulating shareholdings in a foreign corporation solely to obtain the tax benefits under the foreign affiliate regime in the Tax Act that, in the absence of the anti-avoidance rule in paragraph 95(6)(b), would become available as a consequence of the incremental increase or decrease, as the case may be, to the Canadian taxpayer’s shareholding in the foreign corporation. If paragraph 95(6)(b) has this objective in mind, the taxpayers argued that the only relevant purpose is the taxpayer’s purpose underlying the acquisition or disposition of shares in the foreign corporation and not the taxpayer’s motivation for entering into the series of transactions that includes the acquisition of the shares in the foreign corporation.
Despite the taxpayers’ argument, the Tax Court (per Paris J.) agreed with the Minister that the determination of whether the taxpayer’s principal purpose was to avoid, reduce or defer the payment of tax should not be restricted to an examination of the taxpayers’ purpose in acquiring the NAM LLC shares but should instead be expanded to consider the purpose underlying the entire series of transactions undertaken by the CBR Group companies to implement the refinancing of CBR US.
When deciding whether the taxpayers had an offending purpose, the Tax Court found it necessary to identify an alternative series of transactions for purposes of measuring whether the implemented transactions involved an avoidance, reduction or deferral of tax. Here, the NAM LLC loans to CBR US and the taxpayers’ equity investment in NAM LLC were both unwound in 1997 and Lehigh redeployed the proceeds from the original borrowings by investing in the capital of CBR Alta. In turn, CBR Alta used the funds to acquire preferred shares in CBR US. Since the 1997 transactions had the economic result of replacing the financing effected by the transactions that were the subject of the taxpayers’ appeals, the Tax Court felt that the 1997 series of transactions was an appropriate alternative transaction to use in its analysis. When the Tax Court compared the 1995 refinancing transactions and the 1997 refinancing transactions, it found that the Canadian tax consequences under the two scenarios were the same. This led the Tax Court to allow the taxpayers appeal on the basis that there was no avoidance, reduction or deferral of Canadian tax associated with the 1995 refinancing transactions.
Federal Court of Appeal
The Minister appealed the Tax Court decision to the Federal Court of Appeal.
The Federal Court of Appeal (per Stratus J.A.) rejected the Minister’s position that paragraph 95(6)(b) has a broader anti-avoidance purpose than simply addressing situations where Canadian taxpayers manipulate share ownership in foreign corporations to achieve more favourable tax consequences under the foreign affiliate rules in the Tax Act than would be appropriate in the circumstances.
The Federal Court of Appeal found that the words of paragraph 95(6)(b) were clear and unequivocal in requiring the focus to be on the purpose underlying the acquisition or disposition of the shares in the foreign corporation and not the series of the transactions of which the acquisition or disposition forms a part. It also noted that there were numerous provisions elsewhere in the Tax Act where specific words are used to broaden the focus from an individual transaction to a series of transactions and similar language is not found in paragraph 95(6)(b).
The Federal Court of Appeal found further support for a narrower application of paragraph 95(6)(b) from the fact that Parliament had made post-1995 amendments to subsection 17(2) and sections 18.2 (since repealed) and 212.3 to address specific tax avoidance techniques. The Court noted that none of these amendments would have been necessary if paragraph 95(6)(b) had the broad scope urged by the Minister.
Finally, in support of a narrower scope for paragraph 95(6)(b), the Federal Court of Appeal took into account the fact that paragraph 95(6)(b) is found in subdivision i as part of a set of rules specific to the computation of income in Division B of Part I the Tax Act and is not included in Part VI which contains rules that have broad anti-avoidance objectives.
In light of the foregoing, the Federal Court of Appeal concluded that, in determining whether paragraph 95(6) applies to the acquisition or disposition of shares in a foreign corporation, the inquiry is restricted to an examination of the purpose underlying the acquisition or disposition of those shares and, in particular, whether the transaction was designed to cause the foreign corporation to meet or fail the relevant tests for foreign affiliate, controlled foreign affiliate or related-corporation status with a view to avoiding, reducing or deferring Canadian tax. It is open for the Minister to examine the series of transactions of which the acquisition or disposition forms a part but only to the extent that understanding the series of transactions sheds light on the purpose of the share acquisition or disposition.
The Tax Court made a factual finding that the taxpayers’ principal purpose in acquiring their equity interests in NAM LLC, viewed in light of the series of transactions, was to achieve overall US tax savings. The Federal Court of Appeal observed that, in making this finding, the Tax Court implicitly concluded that the taxpayers’ principal purpose was not to manipulate its share ownership of NAM LLC to have NAM LLC inappropriately qualify as a foreign affiliate and thereby gain a Canadian tax benefit. Therefore, the Tax Court was correct to allow the taxpayer’s appeal of the Minister’s reassessments and the Minister’s appeal to the Federal Court of Appeal was dismissed.
The upshot of this case is that it should end the CRA’s longstanding practice of relying on paragraph 95(6)(b) as a broad anti-avoidance rule to potentially support a reassessment of any transaction involving a Canadian taxpayer and its foreign affiliate(s) that the CRA considers to be abusive.
One cannot help but wonder whether the Crown now regrets having appealed the Tax Court decision; in the Tax Court, the Minister had lost the battle but won the war in the sense that, even though the Court found that the principal purpose test was not met in the circumstances of the case, the Tax Court did endorse the concept that paragraph 95(6)(b) could have a broad anti-avoidance purpose beyond simply addressing manipulations of share ownership to inappropriately obtain or avoid foreign affiliate, controlled foreign affiliate or related-corporation status for purposes of the foreign affiliate regime in the Act. However, it may be that the Tax Court’s requirement that the tax consequences of the subject transaction be compared with an alternative transaction was problematic for the CRA’s ability to continue to rely on paragraph 95(6)(b) as anti-avoidance tool in many circumstances.