Loblaw Financial Holdings: Court of Appeal Clarifies the Foreign Bank Exception in the FAPI Rules

On April 23, 2020, the Federal Court of Appeal (FCA) allowed the taxpayer’s appeal of the Tax Court of Canada (Tax Court) decision in Loblaw Financial Holdings Inc. v. The Queen. The case involved almost C$475-million of income earned in 2001–2010 by Glenhuron Bank Limited (Glenhuron), a wholly-owned Barbados bank subsidiary of the taxpayer (Loblaw). The Crown had contended that such income was “foreign accrual property income” (FAPI) that should be taxed in the hands of the taxpayer on a current basis. The FCA decision provides guidance on the interpretation of the “investment business” definition in the FAPI rules, and reaffirms long-standing jurisprudence about the distinction between the capital that enables an enterprise to conduct its business, and the conduct of the business itself.

BACKGROUND

Glenhuron was a Barbados-resident corporation that was licensed and regulated in Barbados as an international bank. Its activities included holding U.S. dollar short-term debt, making loans to third party U.S. persons who distributed baked goods made by a company in the Loblaw group, entering into interest rate swaps, cross-currency swaps and equity forwards with third parties and providing investment management services to members of the Loblaw group. Most of Glenhuron’s funds were obtained by way of equity capital invested by members of the Loblaw group.

If Glenhuron’s income from the above activities was considered to be from an “investment business,” as defined in subsection 95(1) of the Income Tax Act (Canada) (Act), then such income would have been FAPI. Glenhuron was a controlled foreign affiliate of Loblaw and any FAPI earned by it would have been taxed on a current basis in Loblaw’s hands, whether or not it was distributed to the taxpayer.

Generally, if the principal purpose of a business undertaken by a foreign affiliate is to earn income from property—such as interest, dividends, rents and royalties—then the income from that business will be considered to be from an “investment business” and will be included in FAPI. The “investment business” definition has an exception for a foreign bank that is regulated under foreign law, and has more than five full-time employees or equivalents, provided the business is conducted principally with arm’s length parties.

TAX COURT DECISION

The Tax Court found, amongst other things, that the income from the activities carried on by Glenhuron was earned in a business conducted principally with non-arm’s length persons, and therefore did not qualify for the exception to an “investment business.” This was because the Tax Court concluded that Glenhuron’s business was conducted principally with companies in the Loblaw group.

In arriving at that conclusion, the Tax Court placed significant focus on the raising of funds by Glenhuron. As banks are often engaged in moneylending, they may raise funds as part of their banking business, such as by taking customer deposits. Glenhuron did not fund itself by way of third-party customer deposits; its funds came almost entirely from its operations and from equity capital invested by companies in the Loblaw group. In considering what activities encompassed Glenhuron’s “business,” the Tax Court included the investment of capital in Glenhuron by the Loblaw group. In large part, because that was almost all of Glenhuron’s funding, the Tax Court concluded that Glenhuron conducted its business principally with non-arm’s length persons.

THE FCA​’S DECISION

Loblaw appealed the Tax Court decision to the FCA, which reversed the Tax Court’s decision, except with respect to income earned by Glenhuron from investment management services provided to certain other Loblaw group companies. The FCA took issue with several aspects of the approach taken by the Tax Court.

The FCA was concerned that the Tax Court decision failed to acknowledge  long-standing jurisprudence supporting a distinction between “the capital to enable [people] to conduct their enterprises” and “the activities by which they earn their income.” Glenhuron would have devoted little time and attention to the investment of capital in Glenhuron by the Loblaw group. Accordingly, the FCA concluded that such investments were not part of the conduct of Glenhuron’s business.

Once the receipt of funds is removed from the understanding of Glenhuron’s business for the purpose of determining whether it is conducted principally with arm’s length persons, the focus turns to its revenue-generating activities. Since these activities were devoted largely to acquiring and hedging short-term U.S. debt issued by arm’s length parties, they supported the conclusion that Glenhuron conducted its business principally with arm’s length persons.

The Tax Court had also commented that some of the activities undertaken by Glenhuron were undertaken on behalf of other members of the Loblaw group of companies. The FCA said that this did not respect the fundamental principle that a corporation and its shareholders are separate and distinct entities.

The FCA also considered how the term “business” in the “investment business” definition should be interpreted in the context of banking. Referring to a constitutional law decision of the Supreme Court of Canada (SCC) in Canadian Pioneer Management Ltd. v. Labour Relations Board of Saskatchewan (1979), [1980] 1 S.C.R. 433, the SCC adopted a “formal, institutional approach” to defining what is a banking business that would focus on whether the entity was regulated and entitled to call itself a bank. Had such an approach been adopted by the Tax Court, the FCA said there would have been no reasonable basis for concluding that the arm’s length test in the exception to the “investment business” definition requires an examination of both the receipt and use of funds in this case.

The FCA also took issue with the Tax Court’s focus on the fact that Glenhuron did not have to compete with others to obtain funding in concluding that Glenhuron did not conduct its business principally with arm’s length persons. The FCA stated that this amounted to inferring an unexpressed legislative intent, which was not appropriate “in a case which involves a FAPI scheme that is drafted in mind-numbing detail”.

The Crown had submitted that accepting Loblaw’s position would allow taxpayers to maintain investment portfolios offshore without being subject to Canadian income tax. The FCA acknowledged this concern, but reiterated that it could not justify “giv[ing] the legislation a broader interpretation than it can reasonably bear.” The FCA went on to point out that Parliament seemed to have addressed this legislative gap with the introduction in the 2014 budget of subsection 95(2.11) of the Act, which limits the “foreign bank” exception to the investment business definition to foreign affiliates of financial institutions meeting certain conditions.

IMPLICATIONS

By placing such a strong focus on the receipt of funds, the Tax Court blurred the line between fundraising, that is part of a bank’s business, and the raising of long-term capital by a bank. Such an interpretation could have significant implications for the availability of the exception for foreign banks contained in the “investment business” definition in subsection 95(1) of the Act. The FCA’s decision is welcome in that it recognizes that there is a distinction between long-term capital funding activities undertaken by a bank, such as equity contributions, and the raising of funds as part of a bank’s business, such as customer deposits.

For further information, please contact:

Chris Van Loan           416-863-2687

or any other member of our Tax group.