In what many consider to be a surprising turn of events, the Tax Court did not award the successful Respondent its costs in a pivotal case dealing with the FAPI regime contained in the Income Tax Act (the "Act").
Background: Loblaw Financial Holdings Inc. v. HMQ 2018 TCC 182
The primary issue in the underlying appeal was whether, during the 2001-2005, 2008 and 2010 taxation years, the income of Glenhuron Bank Limited (“GBL”) was Foreign Accrual Property Income ("FAPI") and thus taxable in the hands of its parent, Loblaw Financial Holdings Inc. (“Loblaw”).
GBL carried on business in Barbados and was engaged in transactions involving intercompany loans, short-term debt securities, distributor loans and intercorporate loans. Swaps (both cross-currency and interest rate) also yielded returns. This involved using the money from the investments in loans and securities to enter cross-currency swaps which would yield Canadian income, and then using interest rate swaps to exchange Canadian floating rate payments for Canadian fixed rate payments. The swap activity yielded greater income than the loans and debt security transactions.
The Court found that GBL was carrying on an investment business. FAPI includes income from an investment business, but the definition of "investment business" in the Act exempts a business, other than a business conducted principally with non-arm’s length persons, of a regulated foreign bank with greater than the equivalent of five fulltime employees.
The question became: was GBL exempted from the definition of "investment business"? The exemption would apply if GBL could establish it was a) a foreign bank, b) with more than five fulltime employees and c) that the business was not conducted principally with non-arm's length persons.
The Court found that GBL was a foreign bank under the Bank Act. The Court further found that GBL met the test of employing the equivalent of five fulltime employees. In laying the groundwork for the arm's length test analysis, the Court indicated that the two basic elements of a banking business are a) the receipt of funds and b) the use of funds, and that the plain wording of the provision would suggest that a bank must not principally have related customers and must not principally invest in related persons.
Furthermore, the Court found that there should be emphasis on the receipt component, as that is where one would expect to find the competition element. On GBL's receipt side, all funds came from non-arm's length parties. As to the use-of-funds side of the equation, the Court first found that GBL's investment in short term debt securities was not done at arm's length. The Court then found that taking a non-arm’s length person’s money and buying short term debt securities could be viewed as conducting business, although simply buying that type of investment would not involve any negotiation or active conduct of business. The Appellant's position was that because those investments were with third parties, GBL was conducting business with those persons. The Court did not accept this position. The Court's point was that work done to determine where to obtain the best rates would be something carried on for the benefit of the money's owner, and the money's owner in this circumstance was not at arm's length.
With respect to the loan portfolio, the Appellant pointed to thousands of independent operators that received loans from GBL, which the Appellant argued demonstrated it was conducting business with arm’s length persons. However, the Court found that the element of competition was missing. The borrowers were, in the Court's view, simply handed over to GBL by its parent Loblaw. The Court also found that GBL was not paid by the borrowers directly, but rather through a related company. This aspect of the business was found to be conducted as much with Loblaw as with the borrowers.
The Court found that the business of intercompany loans and equity forwards was also conducted with non-arm’s length persons. Furthermore, the swap activity indicated the conducting of business with non-arm’s length persons, because the swaps were subject to Loblaw derivative policies.
Thus, the Court concluded that GBL did not qualify for the foreign institution exemption because GBL's business was principally with non-arm’s length persons. This finding was influenced by the Court's consideration that both sides of GBL's banking business lacked the requisite competitive element.
Did the General Anti-Avoidance Rule ("GAAR") Apply?
There are three conditions for the GAAR to apply, namely, a tax benefit, an avoidance transaction, and misuse or abuse of the provisions of the Act. The Court found that there was a tax benefit (avoidance of tax on FAPI) and that it was achieved through a misuse of the provisions of the Act, but there was no avoidance transaction, since the Court was not persuaded of any transactions having been entered into for purposes other than to make money from an elaborate investment strategy in a low tax jurisdiction.
Costs at Appeal
Following the trial, neither party made representations with respect to costs. Having acknowledged that the Respondent had been successful, the Court stated its inclination not to award costs. However, the door was left open for the parties to make submissions on costs, given that the Court would not have been aware up to this point of any settlement offers having been exchanged. The Court ordered that only a written argument would be permissible.
Costs Decision: Loblaw Financial Holdings Inc. v. HMQ 2018 TCC 263
The Court addressed the parties' submission on Costs and decided that a consideration of the factors in Rule 147 of the Tax Court of Canada Rules (General Procedure) ("Rules") did not support an award of costs to the Respondent.
The Respondent requested costs in the amount of $457,755.82. The Court acknowledged that the Respondent had been successful at trial, but it had only been successful on one issue. The Appellant had been successful in establishing that GBL was a foreign bank, it had the equivalent of more than five fulltime employees, that waivers limited the Respondent's position at trial, and that the GAAR did not apply (no avoidance transaction).
The issue of exchanged settlement offers arose. Subsections 147(3.1) and (3.2) of the Rules did not apply because the offers were not made at least 90 days before trial, but the settlement offers remained a relevant factor to consider in awarding costs.
The Appellant had offered to settle on the primary basis that the GAAR applied for the 2006-2013 years. The Respondent countered on the basis that all assessed amounts from 2001-2012 would be FAPI, but that the foreign exchange gains/losses would be considered on account of income and not capital. The Court found that the Appellant's settlement offer was a true compromise, made before and immediately after trial. In the Court's view, the Respondent's settlement offer (containing only a nominal concession) was neither a compromise nor a good faith attempt to settle. This was not a counteroffer at all, but a rejection of a legitimate offer, and an "emphatic 'let's go to trial' rather than 'let's sit down and settle.'"
The key takeaway would be that a settlement offer should be an attempt to actually compromise, with a genuine view to settlement. Simply suggesting that the appeal be conceded by the opposing party will likely gain little favour with a Tax Court Judge considering a costs award.