Canadian company not liable for tax for foreign affiliate bank, Supreme Court holds

By Doug Connolly, MNE Tax

The Supreme Court of Canada ruled in a December 3 decision that Canadian corporation Loblaw Financial Holdings qualified for an exception from Canadian taxation with respect to its foreign subsidiary Glenhuron, a Barbados-based bank.

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

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

Despite the complexity of the FAPI statutory regime, “the question in this appeal is remarkably straightforward,” the court stated. “Does a parent corporation conduct business with its [controlled foreign affiliate] when it provides capital and exercises corporate oversight? … [T]he 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 it closed in 2013. Loblaw made various capital investments in its Glenhuron subsidiary during this time and operated corporate oversight. However, for the various years at issue, Loblaw did not include income from Glenhuron in its Canadian taxable income, contending that the income was exempt under the FAPI exemption for financial institutions.

The question of whether Loblaw qualified for the FAPI exception for its income from Glenhuron hinged on the issue of whether the bank’s business was conducted principally with non-arm’s length entities.

The Canadian tax authorities denied that Loblaw was eligible for the FAPI exception, and the Tax Court agreed. The Tax Court considered both Loblaw’s capital investments into Glenhuron and its involvement in the management of the bank to be within the scope of the bank’s “business conducted” in the years at issue. This, the lower court reasoned, tilted the scale towards the bulk of Glenhuron’s business being with related parties.

The higher courts disagreed with this characterization. Upon Loblaw’s appeal from the Tax Court, the Federal Court of Appeal determined that Loblaw was, in fact, eligible for the FAPI exception.

Supreme Court’s analysis

The Supreme Court, like the Federal Court of Appeal, determined that the arm’s length requirement is applied to the subsidiaries’ income-earning activities – not to its capital investments or corporate oversight. Excluding investment and oversight activities, the court concluded that “the vast majority” of Glenhuron’s business activities were conducted with arm’s length entities. 

With respect to the notion of treating capital investments as part of the conduct of the bank’s business, the court stated that it has repeatedly affirmed 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 clients of the bank … Shareholders are not.” Moreover, treating capitalization as “conducting business” would “create practical problems” for the FAPI regime, and, in any event, the capital infusions predated the tax years at issue.

Regarding oversight, the court explained that in the case of a controlled foreign affiliate there is necessarily corporate oversight by the parent. Requiring that there be no such oversight for a corporation to meet the arm’s length requirement of the FAPI exception would mean that the exception could never be met. Suggesting that such a requirement would thereby make the exception superfluous, the court noted, “Parliament does not speak in vain.”

With capitalization and oversight excluded, the court found that Glenhuron conducted its business principally with arm’s length entities – finding that “at least 86 percent” of Glenhuron’s income during the years at issue was from such entities. Accordingly, as that was the only contested issue, the court held that Loblaw qualified for the FAPI exception to exclude Glenhuron’s income from its Canadian taxable income.