Tax Insights: Federal Court of Appeal reverses Tax Court of Canada’s decision in Loblaw Financial ─ Arm’s length test in foreign affiliate rules focuses on income-earning transactions

Issue 2020-28

In brief

On April 23, 2020, the Federal Court of Appeal (FCA) rendered its judgment in Loblaw Financial Holdings Inc. v. Canada, 2020 FCA 79. The FCA reversed the Tax Court of Canada (TCC) decision, which had found that Glenhuron Bank Limited (Glenhuron) (a controlled foreign affiliate of the taxpayer) conducted business principally with non-arm’s length persons, for purposes of the foreign bank exclusion¹ in the definition of “investment business” in subsection 95(1) of the Income Tax Act (ITA). The FCA held that Glenhuron’s business qualified for the foreign bank exclusion, meaning that the income from the business was not foreign accrual property income (FAPI) and was therefore not taxable in Canada.

The FCA provided useful guidance for determining whether a business of a foreign affiliate (FA) is conducted principally with arm’s length persons (the “arm’s length test”). This test focuses on the FA’s income-earning activities, and not its capital receipts (e.g. capital invested in the FA by related parties). The test considers all persons with whom the FA had business relationships, not just the counterparties to its business transactions. Although support services provided by the FA’s parent company may be relevant in certain circumstances, these services should not be given significant weight in the analysis.

Although this decision considered the foreign bank exclusion, the arm’s length test is also relevant to other exclusions from the “investment business” definition. The FCA’s decision could therefore be relevant to many types of businesses conducted by FAs.

In detail

Facts

The taxpayer, Loblaw Financial Holdings Inc. (Loblaw Financial), is a Canadian company and an indirect subsidiary of Loblaw Companies Limited (Loblaw), a Canadian public company.

Glenhuron was a Barbados corporation and a direct subsidiary of Loblaw Financial. Glenhuron was licensed as an offshore bank under Barbados banking legislation, and was regulated by the Central Bank of Barbados. During the years under appeal, Glenhuron engaged in several types of financial activities. It invested in short-term debt securities of arm’s length parties, and entered into interest rate and cross-currency swaps in respect of these investments. Glenhuron also purchased a portfolio of loans owing by arm’s length distributors of a related company’s products (and made new loans to these distributors). It also engaged in more limited activities involving managing investments for related corporations, making short-term loans to related companies, and entering into equity forwards to purchase Loblaw shares. Glenhuron was funded initially by capital investments from corporations in the Loblaw group, and later through retained earnings generated by its business activities.

The Minister of National Revenue reassessed Loblaw Financial on the basis that Glenhuron’s business was an “investment business,” meaning that the income earned from this business was FAPI. Loblaw Financial appealed to the TCC.

Tax Court of Canada’s decision

The primary issue considered by the TCC (and the only issue considered by the FCA, below) was whether Glenhuron’s business qualified for the foreign bank exclusion in the definition of “investment business,” so that its business income would be excluded from FAPI. This turned on whether Glenhuron conducted business principally with arm’s length persons.

The TCC found that Glenhuron satisfied every requirement of the foreign bank exclusion, except that its business was conducted principally with non-arm’s length persons. The TCC therefore concluded that Glenhuron’s business was an “investment business,” and that the income from this business was required to be included in Loblaw Financial’s income as FAPI.

In concluding that Glenhuron conducted business principally with non-arm’s length persons, the TCC relied on the following findings:

• the arm’s length test is focused on competitiveness, and requires an examination of a bank’s receipts and uses of funds
• the term “principally” means greater than 50%, but in the foreign bank context, the receipt side of the bank’s business should be given greater relative weight, because this is where competition would be expected
• with respect to the receipt side of business, almost all of Glenhuron’s funds were provided by non-arm’s length parties, and
• although Glenhuron transacted with arm’s length parties, the use side of the business was not conducted principally with arm’s length persons, due to the influence of related parties on these activities; the TCC found that Glenhuron’s activities lacked a competitive element, and that its investment activities were essentially managing funds on behalf of related persons

The Minister had also argued that if Glenhuron’s business was not an “investment business,” the general anti-avoidance rule (GAAR) in section 245 of the ITA would apply. Although the TCC did not need to consider this issue in reaching its decision, it made several obiter comments on the GAAR. The TCC stated that the GAAR could not have applied, because there were no “avoidance transactions” in the years under appeal. However, the TCC did suggest that Glenhuron’s activities could be considered a misuse of the foreign bank exclusion.

Federal Court of Appeal’s decision

The taxpayer appealed to the FCA. The FCA allowed the appeal, and held the TCC had made several legal errors:

• the TCC incorrectly concluded that the arm’s length test in the banking context must consider both the receipt and use of funds 
• the TCC’s focus on competition was misplaced, as Parliament has not explicitly required competition as a component of the foreign bank exclusion, and 
• the TCC failed to respect the distinction between a corporation and its shareholders (which led the TCC to conclude that Glenhuron’s investment activities constituted managing funds on behalf of Loblaw) 

The FCA reviewed the facts, and concluded that Glenhuron’s business was conducted principally with arm’s length parties. The FCA made several key findings in reaching this conclusion:

• the capital investments by the Loblaw group in Glenhuron were not part of the conduct of Glenhuron’s business 
• Loblaw Financial provided direction, support, and oversight to Glenhuron, but this should not be given significant weight in the arm’s length analysis, because 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 to its subsidiary
• the vast majority of Glenhuron’s assets were invested in short-term debt securities, cross-currency swaps, and interest rate swaps, and these activities generated most of Glenhuron’s income; Glenhuron therefore conducted business principally with the persons with whom it entered into these transactions, and Glenhuron dealt with all such persons on an arm’s length basis, and 
• the distributor loans were conducted with related parties, as well as the arm’s length distributors, due to the significant involvement of related parties in arranging these activities; however, these activities represented only a small portion of Glenhuron’s assets and income, and a small amount of its employees’ time

The FCA held that Glenhuron’s business qualified for the foreign bank exclusion, meaning that the income from the business was not FAPI and was therefore not taxable in Canada. The Crown has 60 days to apply for leave to appeal this decision to the Supreme Court of Canada.²

The takeaway

Although this decision considered the arm’s length test in the context of the foreign bank exclusion, the “investment business” definition contains exclusions for other types of businesses, which also rely on the arm’s length test.³ This decision could therefore be relevant to many types of businesses conducted by FAs of Canadian taxpayers.

The TCC’s interpretation of the arm’s length test differed significantly from the way this test had been interpreted by many practitioners, and could have introduced considerable uncertainty. The FCA’s decision therefore provides some welcome guidance. The FCA focused on the application of the arm’s length test to Glenhuron’s specific facts, rather than establishing a clear framework to be used when applying this test to other FAs. However, certain principles emerge from the FCA’s decision: 

• The arm’s length test should focus on income-earning activities conducted by the FA, and not its capital receipts. Accordingly, capital invested in the FA by related parties is not relevant to the test.
• The test considers all persons with whom the FA had business relationships, rather than only persons with whom the FA entered into business transactions. The test does not consider interactions occurring outside of the FA’s business activities. Support services provided by the FA’s parent company may be relevant to this analysis (if these services extend beyond mere oversight); however, they should not be given significant weight.
• The FA’s business relationships must be weighted based on the relevant facts, to determine whether the business is conducted “principally” with arm’s length persons. Based on the factors cited by the FCA in its decision, and the submissions provided by Loblaw Financial (with which the FCA largely agreed), it appears that the following factors may be particularly relevant in this weighting analysis:
  • the value of the income-generating assets
  • the amount of income generated from those assets, and
  • the amount of time, attention, and effort devoted by the FA to the income-generating activities

Although the FCA decision provides helpful guidance, it remains to be seen how the Canada Revenue Agency and the courts will apply this guidance to other fact situations. Taxpayers may wish to review the business operations of their FAs, in light of this new guidance. PwC welcomes the opportunity to assist with this process.

^{1. In general terms, income earned by a controlled foreign affiliate from an “investment business” is included in FAPI (which is defined above). An “investment business” includes a business whose principal purpose is to derive income from property, subject to certain exceptions. The foreign bank exclusion provides an exception from the “investment business” definition. This exclusion generally applies to a business carried on as a regulated foreign bank, which employs more than five full-time employees (or their equivalent), other than a business conducted principally with non-arm's length persons.}

^{2. Subject to any extensions of time provided by the Supreme Court of Canada during the COVID-19 health crisis.}

^{3. Generally speaking, the “investment business” definition contains exclusions for businesses carried on as a foreign bank, a trust company, a credit union, an insurance corporation, or a trader or dealer in securities or commodities, the activities of which are regulated under certain foreign laws. It also contains exclusions for businesses of developing real estate, moneylending, leasing or licensing property, or insuring or reinsuring risks, regardless of whether these businesses are regulated.}