Debt Dumping: Litigation Under the Current Law
The previous article, "Foreign Affiliate Dumping: The Biggest Budget Surprise," deals with budget proposals inspired by debt dumping--the practice of foreign-controlled Canadian corporations borrowing money in order to invest in preferred shares of related non-resident corporations. The other side of this issue is the validity of CRA reassessments on this issue under the current law.
The CRA has been attempting to challenge these transactions under paragraph 95(6)(b), which deems an acquisition or disposition of shares not to have occurred if it can reasonably be considered that the principal purpose for the acquisition or disposition was to avoid, reduce, or defer the payment of tax under the Act. The application of paragraph 95(6)(b) can result in the loss of FA status, in which case dividends received from the non-resident corporation will not be eligible for an exemption.
In the CRA's view, the principal-purpose test can be satisfied when there is an overall tax benefit from a series of transactions that includes an acquisition of shares. Thus, if money is borrowed to finance an investment in preferred shares of a related non-resident corporation and the tax saving from the interest deduction exceeds the net return on the investment (that is, the dividend income less the interest deduction), the CRA will often conclude that the principal purpose for the acquisition is to obtain the tax benefit.
The CRA's position can be questioned on the basis that the scope of paragraph 95(6)(b) appears to be limited to transactions that artificially manipulate share ownership in order to achieve FA status (or to avoid controlled foreign affiliate status). Support for this view is found in the technical notes that accompanied the introduction of the legislation. It is also arguable that the principal-purpose test should be applied to an acquisition of shares without considering ancillary transactions such as a borrowing of money to finance the acquisition. This argument is supported by the fact that there is no "series of transactions" language in paragraph 95(6)(b). On this basis, borrowing to invest in preferred shares of a related non-resident corporation will generally be outside the scope of paragraph 95(6)(b), since the principal purpose for the acquisition (without considering the related borrowing) was to earn a reasonable economic return in the form of dividend income, and not to avoid, reduce, or defer tax.
Unfortunately, there is little case law on the principal-purpose test. The only case that explicitly addresses paragraph 95(6)(b) is Univar Canada Ltd. v. The Queen (2005 TCC 723), where the TCC concluded that a taxpayer that borrowed money to invest in a second-tier financing structure was not subject to paragraph 95(6)(b). Although Univar is a helpful case for taxpayers, the TCC did not consider the scope of paragraph 95(6)(b) in detail. Additional guidance may be coming, however; several unresolved reassessments are yet to be considered by the courts (including a case brought by Imperial Tobacco Canada, which could proceed to trial later this year).
In summary, while the new FA dumping proposals will restrict this activity on a prospective basis, it is questionable whether historical transactions should be subject to paragraph 95(6)(b): the scope of the provision does not appear to be broad enough to capture so-called debt-dumping transactions. It will be interesting to see whether the CRA continues to challenge historical transactions or shifts its focus to prospective transactions only.
Deloitte & Touche LLP, Toronto