By Doug Connolly, MNE Tax

The Supreme Court of Canada ruled on December 3 decision that the Canadian company Loblaw Financial Holdings was eligible for an exemption from Canadian tax with respect to its foreign subsidiary Glenhuron, a bank established in Barbados.

Canadian companies must generally pay taxes on income from controlled foreign affiliates as “foreign accrued property income” (FAPI) – which, the court noted, is “one of the most complicated statutory regimes Canadian law”.

However, an exception generally applies if the foreign affiliate is a financial institution that meets certain requirements. Among these is an “arm’s length requirement” whereby the financial institution must primarily conduct its business with unrelated companies.

Despite the complexity of FAPI’s statutory scheme, “the issue in this appeal is remarkably simple,” the court said. “Does a parent company do business with its [controlled foreign affiliate] when providing capital and exercising corporate oversight? … [T]his answer is an equally straightforward no.

Dispute over arm’s length requirement

Loblaw opened Glenhuron in Barbados in 1992. Glenhuron operated as a corporate bank until its closure in 2013. Loblaw made various capital investments in its subsidiary Glenhuron during this time and exercised corporate oversight. However, for the various years at issue, Loblaw did not include Glenhuron’s income in its Canadian taxable income, arguing that the income was exempt under the FAPI exemption for financial institutions.

Whether Loblaw qualified for the FAPI exception for its income from Glenhuron hinged on whether the bank’s business was conducted primarily with non-arm’s length entities.

Canadian tax authorities denied that Loblaw qualified for the FAPI exception, and the Tax Court agreed. The Tax Court considered Loblaw’s capital investments in Glenhuron and its participation in the management of the bank to be part of the “business carried on” by the bank during the relevant years. According to the lower court, this tipped the balance towards the bulk of Glenhuron’s business with related parties.

The higher courts disagreed with this characterization. Following Loblaw’s Tax Court appeal, the Federal Court of Appeal determined that Loblaw did, in fact, qualify for the FAPI exception.

The Supreme Court’s analysis

The Supreme Court, like the Federal Court of Appeals, determined that the arm’s length requirement applies to the revenue-generating activities of subsidiaries, not their capital investments or oversight of the business. Excluding investment and supervisory activities, the court found that “the vast majority” of Glenhuron’s business activities were conducted with arm’s length entities.

Regarding the notion of treating capital investments as part of the conduct of the bank’s business, the court said that it had repeatedly asserted the distinction between the two. “There is undoubtedly a distinction between receiving funds from depositors and receiving funds from shareholders,” the court noted. “Depositors are customers of the bank…Shareholders are not.” Moreover, treating capitalization as a “commercial activity” would “create practical problems” for the FAPI regime and, in any event, the capital injections predated the tax years at issue.

With regard to supervision, the court explained that in the case of a controlled foreign affiliate, there is necessarily supervision of the company by the parent company. To require that there be no such oversight for a company to meet the arm’s length requirement of the FAPI exception would mean that the exception could never be satisfied. Suggesting that such a requirement would thus render the exception superfluous, the Court noted that “Parliament does not speak in vain”.

With capitalization and oversight excluded, the court found that Glenhuron conducted its business primarily with arm’s length entities – finding that “at least 86%” of Glenhuron’s revenues during the years at issue came from these entities. Therefore, as this was the only issue in dispute, the court found that Loblaw qualified for the FAPI exception to exclude Glenhuron’s income from its Canadian taxable income.

Doug Connolly is editor of MNE Tax. He has over 10 years of experience in tax legal developments, having previously worked with both a Big Four firm and a leading legal publisher. He holds a law degree from the American University Washington College of Law.

Doug Connolly
Doug Connolly

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