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Offshore motivations

Decision is first to clarify rules for ‘tax haven’ hedge fund investments
By Jennifer Leve
March 17 2017 issue

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The recent Tax Court of Canada decision, Gerbro Holdings Company v. Canada 2016 TCC 173, is the first judgment to consider the offshore investment fund (OIF) rules in a situation involving a Canadian taxpayer’s investment in hedge funds that are located in low-tax jurisdictions.

The decision is of interest since it lends clarity to the application of the OIF rules, and in particular, to what constitutes a “main purpose,” as compared to an “ancillary purpose” when determining a taxpayer’s motive in obtaining a tax benefit.

In general, the OIF rules are anti-avoidance rules to discourage taxpayers from investing in investment funds outside Canada in order to reduce or defer Canadian tax. When the OIF rules apply, the taxpayer must include in their income an amount equal to the product of the deemed cost of the investment multiplied by a specified interest rate (currently 1 per cent), plus a notional amount of 2 per cent, for a total of 3 per cent. This imputed amount will be included in income net of any actual income the taxpayer receives from the investment (but not capital gains), and will be added to the cost of the investment so double taxation is limited when the investment is ultimately sold.

In this case, Gerbro was a holding company of a wealthy Canadian family whose sole shareholder was a spousal trust with a substantial inheritance. Gerbro used independent money managers to manage the investments of the spousal trust during the lifetime of the surviving spouse, and its investment portfolio included five hedge funds based in low-tax jurisdictions. The minister assessed the taxpayer and applied the OIF rules for the years in dispute to include imputed income under the OIF rules. Gerbro appealed.

Two tests determine if the OIF rules apply: (1) does the interest in the non-resident entity derive its value primarily from “portfolio investments,” and (2) does the taxpayer satisfy the “Motive Test” (i.e., is one of the main reasons for making the investment in the fund to obtain a tax benefit)?

On the first question, the Tax Court said the investments were portfolio investments since they did not exercise significant influence or control over the property invested in, consistent with the ordinary commercial meaning of the term.

In order to meet the Motive Test under OIF rules, one of the main purposes for making the investment must be to obtain a tax benefit, which can include a deferral of Canadian income tax. The Tax Court held that this test was not met. While tax motivations were part of Gerbro’s decision-making process, the Tax Court found this was not one of the main reasons for the investments. Instead, a compelling set of business reasons, along with the reputations of the investment fund managers, were held to be the dominant reasons for investing.

The Tax Court laid out four reasons for Gerbro’s investment in the offshore funds, referring to Gerbro’s own investment guidelines which supported an overarching bona fide commercial reason for investing:

1. To obtain good returns;
2. To reduce the overall volatility of its portfolio;
3. To invest with trustworthy individuals; and
4. To hold liquid investments.

As well, the Tax Court acknowledged the risk and liquidity needs of the taxpayer, given that the surviving spouse was elderly and that upon her death the trust assets would be distributed to the various heirs of her deceased husband. The Tax Court accepted that Gerbro would not have been able to replicate the underlying investment strategies of the fund managers, and noted that Gerbro neither established nor artificially manipulated the investment funds in order to obtain preferred tax treatment or deferral.

For these reasons, the Tax Court held that while tax motivations influenced the taxpayer’s decision-making, they were ancillary reasons. The Tax Court went on to mention that it was improper to conclude that availability of tax savings should automatically infer this was a main reason for making the investments in the first place, nor should the fact that just because an investment fund is situated in a “tax haven,” the Motive Test is met.

So how is a main reason distinguished from an ancillary reason, especially where the reason is undeclared?

The Tax Court pointed out that the Motive Test is not a purely subjective test, but must be objectively reasonable in the circumstances and validated by fact-specific evidence. The more important the reason for investing, the harder it will be to elevate another reason, such as obtaining a tax benefit, to the same level. However, let us remember Gerbro was able to provide the Tax Court with significant documentation supporting its investment goals; an essential take-away is that taxpayers should carefully document their investment strategies and considerations when making offshore investments.

On Sept. 30, 2016, the Crown filed a notice of appeal challenging both the Tax Court’s application of the legal test in determining a taxpayer’s main reasons for making an offshore investment, and its factual conclusion that none of Gerbro’s main reasons for investing was tax driven. It will be interesting to see whether the Tax Court’s decision is upheld at the Federal Court of Appeal.

Jennifer Leve is an associate with Morris Kepes Winters LLP, a Toronto-based tax law boutique.

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