Loblaw Financial Holdings Inc. v Her Majesty the Queen: Banking on Barbados
The Supreme Court of Canada (“SCC”) is usually timid to grant leave to tax law cases. However, earlier this year, we saw the SCC decide MacDonald v. Canada 2020 SCC 6. (You can find our case comment on MacDonald here.) The SCC also granted leave to Canada v. Alta Energy Luxembourg S.A.R.L. 2020 FCA 43 in August.
Recently, the SCC granted leave to another major tax law case from the Federal Court of Appeal (“FCA”): Loblaw Financial Holdings Inc. v Her Majesty the Queen, 2020 FCA 79 [Loblaw Financial]. This case is important in clarifying the Foreign Accrual Property Income (“FAPI”) provisions of the Income Tax Act RSC 1985, C-1 (5th Supp.) (the “Act”) for tax planners and corporations.
The SCC will decide whether the FCA incorrectly overturned the Tax Court of Canada’s (“TCC”) decision, which addressed how the arm’s length test is examined under the FAPI provisions. The FCA’s overturn of the TCC’s decision is a major win for the taxpayer, who was facing tax liabilities of $368 million.
Facts and Issues
Loblaw Financial is a Canadian corporation owned by Loblaw Companies Limited (“Loblaw”), which is in turn owned by George Weston Limited (“Weston”). All parties deal in a non-arm’s length manner.
The arm’s length principle generally refers to a business relationship where the parties are independent of each other. For example, because Loblaw Financial is owned by Loblaw, they are non-arm’s length parties. But Walmart and Loblaw would likely be arm’s length parties such that they are independent of each other.
Loblaw Financial incorporated a new subsidiary in Barbados in the 1990s for tax purposes. Loblaw Financial then approached the Central Bank of Barbados to license its Barbados subsidiary as an offshore bank. The Central Bank agreed to do so pursuant to the Off-shore Banking Act, Cap. 325, which was later replaced by the International Financial Services Act, SC 2018, C27, S659 (“IFSA”). The Barbados subsidiary changed its name to Glenhuron Bank Limited (“Glenhuron”) after receiving its license (Loblaw Financial, paras 7-9).
The IFSA limited Glenhuron’s activities to the definition of “international banking business.” These activities include receiving foreign funds and property and using said funds for loans, investments, or similar activities (Loblaw Financial, para 12).
In 2013, Loblaw liquidated Glenhuron to fund a major acquisition. Between Glenhuron’s inception and 2013, the bank engaged in several types of financial activities (Loblaw Financial, para 16):
- Purchased low risk, short-term debt securities;
- Entered into interest rate and cross-currency swaps;
- Purchased and managed a portfolio of loans from Weston and subsequently sold the portfolio. Weston had extended these loans to independent drivers of their bakery products;
- Managed investments on behalf of corporations part of Loblaw and Weston for a fee;
- Made loans to non-arm’s length corporations; and,
- Entered into equity-forward contracts to purchase Loblaw shares.
Loblaw invested capital in Glenhuron through share capital and interest-free debt prior to the taxation years at issue. Funding increased during operational years through retained earnings (Loblaw Financial, paras 11 and 18).
The Minister of National Revenue reassessed Loblaw Financial for its 2001-2005, 2008, and 2010 taxation years. The Minister determined that Loblaw Financial had to pay tax on Glenhuron’s income due to the FAPI provisions in the Act (Loblaw Financial, para 2). The FAPI provisions require Canadian companies to include the passive income of their foreign subsidiaries into their taxable Canadian income. This prevents corporations from avoiding tax through earning passive income through foreign corporations (commonly subsidiaries) located in low-tax jurisdictions (Loblaw Financial, para 19).
The distinction between active business income and passive income is key to the FAPI provisions. Active business income is not subject to FAPI while passive income is. One form of passive income is operations defined as an “investment business” in subsection 95(1) of the Act (Loblaw Financial, paras 21-22). The definition in subsection 95(1) also indicates exceptions. For example, the “investment business” definition excludes businesses that subsection 95(1) defines as a “foreign bank”.
Loblaw Financial’s submissions are based on the foreign bank exemption. However, the exception doesn’t apply to “any business conducted principally with persons with whom the affiliate does not deal at arm’s length”, such that the Canadian shareholder and foreign bank must deal at arm’s length to meet the exception to subsection 95(1)’s definition of “investment business”.
The Tax Court of Canada Decision
The TCC made three findings with respect to FAPI (Loblaw Financial, para 25):
- Glenhuron was a foreign bank that principally conducted business with non-arm’s length persons — therefore, the Court determined Glenhuron’s operations as an investment business and included its income in Loblaw Financial’s Canadian income under the FAPI provisions;
- Glenhuron’s fee income from managing investments for non-arm’s length persons was FAPI; and,
- The gains and losses from foreign exchange with respect to investment in short-term debt was FAPI.
Based on these findings, the TCC ordered a reassessment on the relevant tax years only with respect to foreign exchange. Otherwise, the Minister’s determination was upheld (Loblaw Financial, para 26).
Loblaw Financial appealed this decision to the FCA, where the only issue was what constitutes “arm’s length”. The TCC decision found that with regards to the arm’s length test and Loblaw Financial,
- In the context of foreign banks, courts must examine the bank’s receipts and use of funds;
- “Principally” means greater than 50% of business and is determined on all relevant circumstances. With foreign banks, courts should place greater weight on the receipt side because this is where competition is expected;
- All of Glenhuron’s receipts were from non-arm’s length parties; and,
- The use of funds was principally used to conduct business with non-arm’s length persons.
Loblaw Financial appealed this decision to the FCA, where the key issue was what constituted “arm’s length”.
The Federal Court of Appeal Decision
Loblaw Financial’s Submissions
Loblaw Financial submitted that the TCC made four errors of law (Loblaw Financial, para 33):
- it read in an unlegislated competition requirement;
- it focused on capitalization rather than sources of income;
- it characterized the conduct of business as including capital receipts; and,
- it failed to treat Glenhuron as separate and distinct from Loblaw.
Further Loblaw Financial submitted that “a proper interpretation of the arm’s length test frames the issue as to whether the foreign bank generated income by investing in, or with, arm’s length Persons” (Loblaw Financial, para 34). This interpretation of the arm’s length test would only find Glenhuron subject to FAPI rules if it generated income by investing in, or with, Loblaw, Weston, or other non-arm’s length parties. If true, the Court wouldn’t find income generated by short-term debt securities or swaps as FAPI. Loblaw Financial conceded that loans made to Weston’s bakery drivers would remain as FAPI.
The FCA’s findings
The FCA identified the main issue as who Glenhuron principally conducted business with (Loblaw Financial, para 43). The Court found that:
- “Business conducted…with” suggests “every person with whom Glenhuron has a business relationship with” (Loblaw Financial, para 44); and,
- “The business relationships must be weighted to determine with whom the corporation principally conducted business” (Loblaw Financial, para 45).
The FCA found that the TCC had erred in concluding that the arm’s length test requires examination of the bank’s activities from both a receipt and use of fund perspective (Loblaw Financial, para 53). The error arose due to the TCC’s dependence on “international banking business” as defined in Barbados legislation. The Court ruled that “[s]imply because Barbados legislation defines international banking in a particular manner does not mean that receipts and uses are always a necessary requirement to carry on a banking business – in Barbados or elsewhere” (Loblaw Financial, para 54).
The Court further stated that the TCC’s error in law led to two incorrect conclusions (Loblaw Financial, para 57):
- that the receipt side of the business implies an element of competition; and,
- that the necessity for business receipts means that the exclusion doesn’t apply if a business simply manages its own funds.
The “element of competition”—such that Glenhuron should’ve had to compete with other banks to obtain funds from Loblaw—component was troubling as the TCC’s reasons inferred a factor in FAPI analysis not expressed by legislation. The FCA noted that this was not appropriate because the “FAPI scheme is drafted with mind-numbing detail” (Loblaw Financial, para 58).
Lastly, the FCA took issue with the TCC’s determination that Glenhuron acted on behalf of Loblaw in Glenhuron’s investing and asset management activities. The FCA concluded that Glenhuron had managed its own money and not Loblaw’s (Loblaw Financial, para 62).
The FCA concluded that Glenhuron principally conducted business with the counterparties of its short-term debt securities and swap transactions on an arm’s length basis. The Court also provided the following policy rationale for its decision:
The FAPI regime as a whole, and the foreign bank exclusion in particular, is intended to encourage Canadians to carry on active businesses outside Canada. Parliament could not have intended that the foreign bank exclusion should be denied as a result of support and oversight provided by a parent corporation. The legislative intent would be frustrated if these interactions with Loblaw Financial were to be given significant weight.
The Crown submitted that the “arm’s length test requires the Court to consider both Glenhuron’s use of funds and receipt of funds” (Loblaw Financial, para 79). The Court recognized that the applying meaning of “business” was defined as “something occupying the time and attention and labour of a man for the purpose of profit” (Loblaw Financial, para 82). Applying such a definition, there was no reason to believe that Loblaw’s invested capital in Glenhuron occupied the time and attention of Glenhuron in any meaningful way (Loblaw Financial, para 84). The Court claimed this approach was “consistent with long-standing jurisprudence which draws a distinction between ‘capital to enable [people] to conduct their enterprises’ and ‘the activities by which they earn their income’” (Loblaw Financial, para 85).
The FCA also considered the Crown’s argument that “if Loblaw Financial’s position is accepted, the very target of the FAPI legislation, which is an investment portfolio held offshore, would be exempt.” (Loblaw Financial, para 86). As a result, it concluded that “Glenhuron’s FAPI was limited to its income in relation to investment management services provided to non-arm’s length persons” and referred the reassessment back to the minister on this basis (Loblaw Financial, para 87).
Implications – All eyes on Loblaw
The SCC will likely clarify whether parties that fund a bank’s business are considered a party that the bank “principally” conducts business with, as stated by the TCC. Alternatively, the SCC may affirm the FCA’s decision and find that the receipt side doesn’t play a role.
The FAPI provisions of the Act are complex. The SCC will ultimately clarify some of the rules surrounding FAPI, which has implications on large multi-national enterprises in Canada and on Canadian corporations who use offshore banking structures similar to Loblaw. Foreign banks that raise capital from Canadian institutions will likely also have their eyes on this decision. Lastly, as Loblaw’s tax liability stands at $368 million, which is a large amount that could either be gained or lost for the government’s treasury.