Gerbro Holdings Company v. Canada

Gerbro Holdings Company v. Canada
Court (s) Database
Tax Court of Canada Judgments
Date
2016-07-22
Neutral citation
2016 TCC 173
File numbers
2012-4194(IT)G, 2012-739(IT)G
Judges and Taxing Officers
Lucie Lamarre
Subjects
Income Tax Act
Decision Content
Dockets: 2012-739(IT)G
2012-4194(IT)G
BETWEEN:
GERBRO HOLDINGS COMPANY,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Appeals heard on November 3, 4, and 5, 2014
and June 22, 23 and 24 at Toronto, Ontario
and November 16, 2015, at Montreal, Quebec.
Before: The Honourable Lucie Lamarre, Associate Chief Justice
Appearances:
Counsel for the Appellant:
Stéphane Eljarrat
Joel Scheuerman
Counsel for the Respondent:
Naomi Goldstein
Rita Araujo
JUDGMENT
The appeal from the reassessments made under the Income Tax Act (ITA), for the taxation years ended on December 31, 2005 and December 31, 2006, are allowed and the reassessments are referred back to the Minister of National Revenue for reconsideration and reassessment on the basis that Gerbro did not have to report for the taxation years ended on December 31, 2005 and December 31, 2006, income in the amounts of $841,803 and $754,210 respectively imputed to it under section 94.1 of the ITA.
If either of the parties requests to make submissions on costs, both parties shall file written submissions with the Registry on or before August 31, 2016. If no submissions are received, the Appellant will be awarded one set of costs for the two appeals (2012‑739(IT)G and 2012‑4194(IT)G).
Signed at Ottawa, Canada, this 22nd day of July 2016.
“Lucie Lamarre”
Lamarre A.C.J.
Citation: 2016 TCC 173
Date: 20160722
Dockets: 2012-739(IT)G
2012-4194(IT)G
BETWEEN:
GERBRO HOLDINGS COMPANY,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
REASONS FOR JUDGMENT
Lamarre A.C.J.
1 INTRODUCTION [1] The appellant, Gerbro Holdings Company (Gerbro), is appealing from two assessments made by the Minister of National Revenue (Minister) with respect to its taxation years ending on December 31, 2005 and December 31, 2006 (Relevant Period). The two appeals were heard on common evidence. The Minister's assessments imputed to Gerbro income of $841,803 for 2005 and $754,210 for 2006 under section 94.1 of the Income Tax Act (ITA) in respect of Gerbro's investments in the following five offshore investment (hedge) funds (collectively, the Funds):
1. The Raptor Global Fund Ltd. (Raptor);
2. Arden Endowment Advisors Ltd. (Arden);
3. M. Kingdon Offshore Ltd. (Kingdon);
4. Haussmann Holdings N.V. (Haussmann); and
5. Caxton Global Investments Ltd. (Caxton).
[2] Section 94.1 is an anti-avoidance provision which applies where (1) a taxpayer's interest in a non-resident entity derives its value, directly or indirectly, primarily from portfolio investments in listed assets, and (2) it may reasonably be concluded, having regard to all the circumstances, that one of the main reasons for the taxpayer acquiring, holding or having the interest in the non‑resident entity was to pay significantly less Part I taxes than would have been payable if the taxpayer had held the portfolio investments directly. I will refer to the rules set out in section 94.1 as the offshore investment fund property rules (OIFP Rules).
[3] The essence of the Respondent's position is that all the Funds derived their value primarily from portfolio investments and that Gerbro, being a sophisticated investor, invested with an intention to reduce or defer Canadian taxes, as contemplated by the concluding part of the subsection. This position is premised on the low or non‑existent taxation in the jurisdiction in which the investment vehicles of the Funds were located, on the fact that the hedge funds selected made no distributions to their shareholders, as well as on the existence of other tax‑motivated transactions that Gerbro entered into over time.
[4] The Appellant, on the other hand, argues that section 94.1 does not apply since neither of the two above-stated requirements is met. It submits that (1) the Funds did not derive their value primarily from portfolio investments in listed assets, and (2) that none of Gerbro's main reasons for investing in the Funds was to reduce or defer Canadian taxes. In its Amended Notice of Appeal, the Appellant stated that it invested in the Funds to complement its investments in traditional long equities, in order to meet its primary objective of capital preservation which is set out in its investment guidelines.[1]
[5] The evidence adduced at trial does not support the Appellant's position that the Funds did not primarily derive their value, directly or indirectly, from portfolio investments in listed assets. However, the appeal must succeed on the basis that, having regard to all the circumstances, it may reasonably be concluded that none of Gerbro's main reasons for investing in the Funds was to defer or avoid Canadian taxes as contemplated by the OIFP Rules.
2 FACTS [6] The parties have agreed on some of the relevant facts and these are set out in a Statement of Agreed Facts (Partial) which is attached as Appendix A to these reasons for judgment. I will summarize the key facts.
2.1 Appellant's Interpretation of the Facts [7] In 1986, the late Gerald Bronfman left a substantial inheritance for Marjorie Bronfman in a spousal trust (MB Trust) and Gerbro was established as a holding company tasked with investing the MB Trust's capital and income during Ms. Bronfman's lifetime. Gerald Bronfman's last will and testament further provided that the remaining capital and income would go to Marjorie's four children following her death.[2] In the Relevant Period, Ms. Bronfman had already reached the age of 88 years, which was why Gerbro's investments had to be liquid.
[8] Ms. Nadine Gut held the position of president of Gerbro. Before being appointed president, she had been a part‑time (from the company's inception) and then full‑time (as of June 1990) employee of Gerbro.[3]
[9] Gerbro was a Canadian-controlled private corporation incorporated under the Canada Business Corporations Act [4] with a fiscal year‑end of December 31, and its sole shareholder was the MB Trust.[5] Gerbro chose to use independent money managers to manage its investments since it did not have the resources in-house to actively manage its own portfolio. Nonetheless, Gerbro expended significant resources to make allocation decisions with respect to the MB Trust's capital in accordance with the applicable investment guidelines.
2.1.1 Investment Policies and Guidelines [10] Gerbro's board of directors adopted its first written investment guidelines in 1992,[6] in which they codified the capital preservation investment philosophy Gerbro already adhered to. Subsequent amendments to the 1992 investment guidelines did not change Gerbro's investment philosophy of capital preservation. In essence, the amendments to the investment guidelines refined Gerbro's policies for selecting managers as well as its portfolio allocation guidelines. They also updated historical figures influencing the minimum expected return requirement for achieving capital preservation, such as the rate of inflation and Gerbro's operating costs. A set of investment guidelines adopted in April 2002 (2002 Guidelines)[7] was still in force at the beginning of the Relevant Period, but was updated by a new set of guidelines in April 2005 (2005 Guidelines).[8] The 2002 Guidelines included an appendix that was a checklist for selecting and replacing investment managers.
[11] Although Gerbro's main objective was capital preservation, like most investors, it had as a secondary objective earning a return consistent with prevailing market expectations. This meant that if the markets were achieving good returns, Gerbro also wanted to benefit from the higher than normal returns, subject to the level of volatility being acceptable.
[12] Moreover, the money Gerbro invested had to be allocated to investments that (i) were liquid, (ii) provided Gerbro with sufficient cash to pay its yearly operating costs as well as its yearly tax liabilities, and (iii) provided Marjorie Bronfman with enough cash to sustain her lifestyle and to fully carry out her philanthropic endeavours.[9]
[13] Gerbro referred to the applicable investment guidelines to make its investment allocation decisions. To achieve the objective of capital preservation, the 2005 Guidelines fixed a minimum return of 6.5%. The prevailing rate of inflation, the operating expenses of Gerbro and the annual expenses of Marjorie Bronfman were considered in order to arrive at this target rate of return. To this expected return criterion, the 2005 Guidelines attached a target volatility of 10%, which served as a gauge of risk.[10]
[14] In addition, the 2005 Guidelines set upper and lower allocation percentages for five distinct asset classes as follows:[11]
Minimum Allocation
Maximum Allocation
Cash
0%
5%
Bonds [Fixed Income]
10%
30%
Equities ***
30%
60%
Directional [Hedge] Funds *
0%
30%
Non-directional [Hedge] Funds
0%
30%
* The maximum allocation for equities and directional funds combined is 60%.
** International equities as a sub group of equities could have an allocation of 0% to 30% of the combined portfolio.
[15] Nadine Gut's testimony established that Gerbro rigorously followed its well‑defined objectives set out in its investment guidelines. In the Relevant Period, the percentages Gerbro actually allocated to each of the five asset classes were consistent with the above-referenced allocation percentages.[12]
2.1.2 Evolution of Portfolio Allocation [16] At its inception, Gerbro retained SEI Investments, an investment management firm, to build a suitable portfolio.[13] Subsequently, Gerbro did much of the due diligence work preceding allocation decisions internally, and its allocation decisions were presented to and approved by its investment committee (Investment Committee).
[17] From 1993 to 2001, Gerbro retained Sandra Manzke from Tremont (a consulting firm located in the state of New York) to act as a consultant in searching for hedge fund managers. Ms. Manzke helped Gerbro identify potential hedge fund managers which had at least three years of proven positive returns and at least $100 million of assets under management. Most managers Tremont suggested to Gerbro were based in the United States.[14]
[18] Gerbro argued forcefully that it did not restrict its search for managers to United States managers and supported this assertion with examples of some Canadian managers it had historically invested with. From 2003 to 2006 it invested in Maple Key Limited Partnership, but divested itself of that investment due to disappointing returns. Gerbro redeemed an investment it had made around the year 2000 with another Canadian manager, Boulder Capital Management, later renamed Silvercreek Limited Partnership, due to accounting fraud related to the Enron scandal.[15]
[19] In the early 1990s, Gerbro invested amounts of $1 to $2 million with celebrity world hedge fund managers such as George Soros.[16] In those years Gerbro benefited from the exceptional returns those hedge fund managers produced on currency plays.
[20] It appears from the minutes of Gerbro's board of directors' meeting held on January 28, 1993 that Gerbro considered adding hedge funds to its portfolio as a means of protecting itself from a potential meltdown of financial markets.[17] This suggestion originated from one director, Mr. Schechter, who spoke about the benefits of increasing Gerbro's percentage allocation to hedge funds.
2.1.3 Similarities Among the Funds [21] The investments in the Funds ensued progressively. In 2005, Gerbro acquired and held shares in Raptor, Arden, Kingdon and Haussmann. In 2006, Gerbro acquired and held shares in Caxton, Raptor and Haussmann.
[22] All the Funds were subject to annual management fees, ranging from 1% to 3%. Moreover, all the Funds, aside from Haussmann, had to pay an incentive performance fee ranging from 10% to 30% above a high-water mark.
[23] Another similarity is that all the Funds were located in low‑tax jurisdictions and therefore paid only a nominal amount of tax, if any at all. Raptor and Arden were registered as exempted companies under the Companies Law of the Cayman Islands.[18] Kingdon and Haussmann were incorporated in the Netherlands Antilles.[19] Lastly, Caxton was registered as an exempted company under the laws of the British Virgin Islands.[20]
[24] Gerbro submitted that it could not replicate the investment strategies of the Funds for lack of exact knowledge about the investments each Fund carried and for want of the financial resources required to replicate sophisticated investment strategies. The lack of exact knowledge also meant that it could not calculate the amount of Part I tax that it would have paid if it had hypothetically held the Funds' investments directly. The competitive advantage of each Fund consisting in the research leading up to investment decisions and in the alternative trading strategies their respective managers used, the Funds did not disclose their basket of assets to investors. In some cases, notably Raptor, the managers provided information on select trades after the fact.[21]
[25] Gerbro contends that it was never invited to invest in the onshore vehicles of the Funds. It should be noted that all investments in the Funds had equivalent onshore investment vehicles in the United States, except for Haussmann.[22] When an investor was admitted to invest in the Funds, the manager would direct the investor to the appropriate investment vehicle. Given that the hedge funds were unregulated investments, the managers had full discretion to accept an investor, and if the investor was accepted, to decide in which investment vehicle that investor could subscribe for shares.
[26] According to Ms. Gut's testimony, the jurisdiction that the fund was located in was not relevant in deciding whether to invest in any of the Funds.[23] The information about the low-tax jurisdiction was in the offering memorandum of each Fund. The memoranda were only provided to Gerbro as a formality prior to it making an investment. At that point, the Investment Committee had already made the decision to subscribe for shares.
[27] Although the managers of the Funds had a discretionary power to declare dividends, they did not declare any dividends for Raptor, Caxton, Arden and Kingdon in the Relevant Period. Gerbro received relatively small dividends from Haussmann as compared to the size of its investment in that Fund, which exceeded $5 million at all times during the Relevant Period. The dividends it received from Haussmann were in the amounts of $8,915.82 in 2005 and $26,311.44 in 2006.[24]
2.1.4 Particularities of each of the Funds [28] While they had many similarities, the Funds were distinct in the strategies that they employed and should be described separately in some detail.
2.1.4.1 Haussmann [29] Haussmann is a hedge fund of funds, which means that Haussmann achieved capital appreciation by building a portfolio composed of other hedge funds. The fund was managed by a group of advisors, including Mirabaud, a bank with which Gerbro transacted business. Coincidentally, Haussmann also invested in Raptor and Kingdon.[25] Haussmann was able to invest in a multitude of funds since it pooled money from many investors.
[30] That investment fell within Gerbro's directional hedge fund asset class, and the hedge funds Haussmann invested with were allowed to buy and sell securities, options, commodity futures and foreign currencies.[26] The hedge funds were also allowed to engage in leveraging and in sophisticated trading strategies using derivatives.
[31] Gerbro's stated reasons for investing in Haussmann were twofold. Firstly, it wanted to gain access to many hedge funds to which it could not have access on its own. Haussmann was able to get access to them because of the large amounts of money it invested. At the time, the fund had $4 billion worth of assets under management.[27] Gerbro asserts that, due to this economic disparity alone, it could not have replicated Haussmann's strategy.[28] Secondly, by investing with Haussmann, Gerbro benefited from a wealth of knowledge about financial markets which Haussmann had acquired from speaking to many managers it had either invested with or considered investing with.
[32] In addition, Haussmann is the only one of the Funds that is publicly traded. Its stock traded on the Irish Stock Exchange.[29] The fact that it is publicly traded was relevant to the extent that Haussmann would have qualified as an exempt interest under the proposed foreign investment entity rules (FIE Rules),[30] which rules will be addressed later on in my reasons.
2.1.4.2 Raptor [33] Raptor was managed by James Pallotta and had approximately $9 billion worth of assets under management when Gerbro invested in 2005. The iconic Paul Tudor Jones brought James Pallotta into the Tudor Group, and Mr. Pallotta formed the Raptor fund under the umbrella of the Tudor Group. Gerbro was never extended the opportunity to invest directly with Paul Tudor Jones, but Mirabaud brokered a sale of Raptor shares to Gerbro.[31]
[34] This investment fell within Gerbro's directional hedge fund asset class and was primarily in equities, both long and short, and in related derivatives. These types of investments included common stocks, preferred stocks, warrants, options, bonds, repurchase agreements, reverse repurchase agreements and contracts for differences.[32]
[35] Gerbro's only stated reasons for investing were James Pallotta's past performance, his reputation in the industry and Raptor's low historical volatility.[33] These reasons appear in an internal memorandum dated February 28, 2005 from Daniel Conti, a Gerbro employee, to Ms. Gut.[34]
[36] The fund is set up as a master‑feeder structure, where Raptor is an offshore feeder fund for Raptor Global Portfolio Ltd (Global), the master fund.[35] Global was the legal entity that traded in all of the assets, however, its objectives were aligned with those of Raptor. James Pallotta offered investment advice to Global through the Tudor Investment Corporation, a Delaware company.[36] The Raptor Global Fund Limited Partnership (Raptor LP) was the onshore feeder fund for Global.[37]
[37] Subject to limited exceptions, anyone with ties to the United States, whether an individual or a corporation, was excluded from holding shares in the Raptor feeder fund.[38] Instead, such persons could have been invited to invest in the onshore Raptor LP.
2.1.4.3 Arden [38] Arden was managed by Averell H. Mortimer and was a fund of funds. Mr. Mortimer provided advice through Arden Asset Management Inc., a company incorporated under the laws of New York of which he was the president.
[39] This investment fell within Gerbro's non-directional hedge fund asset class, that is, its focus was on finding investments with low correlation to equity financial markets. To achieve this low correlation, Arden invested in other hedge funds that traded in, among other things, securities, fixed-income instruments, derivatives on the fixed-income instruments, commodity futures, options on futures, securities of companies undergoing extraordinary corporate transactions and securities of companies in difficulty.[39]
[40] Gerbro's only stated reason for investing in Arden was Averell H. Mortimer's ability to achieve market-neutral returns which introduced diversification into, and reduced volatility in, Gerbro's portfolio. According to Ms. Gut, adding Arden to its portfolio would significantly reduce the portfolio's volatility.[40] This statement was supported with statistical analyses that Gerbro conducted in 2005.[41] The investment was thus expected to contribute to achieving Gerbro's target volatility of 10%.
[41] On December 1, 2005, in response to the proposed FIE Rules, Gerbro entered into a year-end transaction whereby it sold all of its Arden shares to its wholly-owned subsidiary Woodrock Canada Inc. (Woodrock) by way of a reduction of capital.[42] The purpose of this transaction was to efficiently comply with the proposed FIE Rules. Selling the Arden shares to Woodrock allowed Gerbro to remain exposed to Arden while optimizing its Canadian tax structure in light of the FIE Rules.[43] This year-end transaction triggered a capital gain of $523,689 in Gerbro's 2005 fiscal year.[44]
2.1.4.4 Kingdon [42] Gerbro made its first investment in Kingdon in 1994, and did so because of the reputation and performance of its manager, Mark Kingdon. Gerbro's management team was impressed with Mark Kingdon's credibility and integrity.
[43] The investment in Kingdon fell within Gerbro's directional hedge fund asset class.
[44] In 2005, Kingdon was structured as a stand-alone fund and received investment advice from Kingdon Capital Management LLC, a Delaware company.[45] Kingdon used an internally developed asset allocation model to allocate its assets primarily among investments in common stock and bonds.[46]
[45] On December 1, 2005, Gerbro entered into a year-end transaction whereby it sold all of its shares of Kingdon to Woodrock by way of a reduction of capital in response to the proposed FIE Rules.[47] This year-end transaction triggered a capital gain of $1,769,977 in Gerbro's 2005 fiscal year.[48]
2.1.4.5 Caxton [46] In 2006, when given the opportunity to subscribe for shares in Caxton, Gerbro invested because of Caxton's performance and the fund's low correlation with other investments in Gerbro's portfolio. The low correlation was due to the fact that Caxton traded primarily in commodities and that commodities had low correlation with equity markets. Gerbro attributed Caxton's success to its manager Bruce Kovner. [49]
[47] The fund was set up as part of a master-feeder structure in which Caxton was an offshore feeder fund for Caxton International Limited (Caxton Limited), the master fund.[50] Caxton Limited was a subsidiary of Caxton, and was the legal entity that purchased, held and sold all of the assets. Its objectives were aligned with those of Caxton. Bruce Kovner offered investment advice to Caxton Limited through Caxton Associates LLC, a Delaware company. Caxton Global Investments (USA) LLC was the onshore feeder fund for Caxton Limited.[51]
2.1.5 Calculation of Part I Tax Otherwise Payable in the Auditor’s Report [48] Gerbro submits that, in the auditor’s report, Mr. Joseph Armanious incorrectly calculated tax that would otherwise have been payable if Gerbro had held the Funds’ investments directly. The auditor did not have an exhaustive list of the trades with the adjusted cost base and proceeds of disposition for each asset, nor did he have any information about the timing of the dispositions during the year. To make up for the lack of information, the auditor calculated the taxes otherwise payable using information available in the Funds' financial statements. He looked at the total amount of realized gains in the year for each of the Funds, which were expressed in United States dollars, regardless of when the gains were realized during the year. He pursued his calculation by converting the realized gains appearing on the financial statements into Canadian dollar gains using the Bank of Canada average exchange rate for each fiscal year. Finally, the auditor multiplied the converted Canadian dollar gain by Gerbro's tax rate for the Relevant Period to obtain the amount of taxes otherwise payable with respect to each Fund.[52] The auditor compared these amounts with the negligible amount of tax each Fund paid offshore and arrived at the conclusion that the Funds paid significantly less tax than would have been payable if Gerbro had held the Funds' investments directly. Joseph Armanious, the auditor for the CRA, testified at trial that this was the process he followed.
[49] The Appellant vigorously defends the position that the calculation of Canadian income taxes otherwise payable contained in the auditor's report is flawed. In that regard, the Appellant emphasizes that the auditor's calculation was legally inaccurate since it is at odds with the recognized method set out in Gaynor (H.R.) v. M.N.R.[53]
[50] Gerbro further argues that the practical impossibility, due to the nature of investments in hedge funds, of calculating the amount of tax otherwise payable points up the fact that this factor should not be given a great deal of weight in inferring an intention to avoid or defer taxes. As previously explained, hedge funds, in order to maintain their competitive advantage, do not disclose the nature and timing of specific trades.
2.2 Facts Added by the Respondent [51] The Respondent added the fact that Gerbro's directors were knowledgeable about tax matters, given their professional backgrounds, and therefore could not have been unaware of the significant tax benefits associated with investing in the Funds when they approved them. Ms. Gut and David G. Broadhurst held a chartered accountant’s professional designation, while Samuel Minzberg and Hillel W. Rosen were lawyers with a leading law firm. Of these lawyers, the former had a practice in taxation and the latter in mergers and acquisitions.[54]
[52] Moreover, the Respondent lists numerous documents that allegedly prove that Gerbro always considered the reduction or avoidance of tax when investing in hedge funds, which involved discussions about the efficient reallocation of assets from one manager to another in segregated accounts, tax‑motivated transactions to respond to the FIE Rules or judgments on the tax efficiency of existing or potential investments.[55]
[53] She adds that the “one of the main reasons” test is applied not only to the reasons for investing at the moment at which the investment is made, but also to the reasons for continuing to hold the investment in the non-resident entity.
[54] In addition, the Respondent points to the Funds' policy of reinvesting income rather than making distributions to its shareholders as an indicator that the managers of the Funds considered the Canadian tax aspect.[56]
[55] The Respondent also criticizes Gerbro for having called only Ms. Gut to testify regarding Gerbro's main reasons for investing in the Funds, rather than calling other employees to corroborate Ms. Gut's version. She asks the Court to draw a negative inference from this.
[56] On the topic of equivalent Canadian investments, the Respondent rejects Gerbro's assertion that they did not limit their search for hedge funds to United States hedge funds, as well as the broader assertion that there were no comparable Canadian hedge funds with equivalent characteristics to those of the Funds.
[57] While the Appellant called Mr. Luis Seco to testify as to the accuracy of that opinion, the Respondent urges the Court to discard his expert report. The reason put forward is that the report is non-compliant with the Code of Conduct for Expert Witnesses, Schedule III to the Tax Court of Canada Rules (General Procedure).
[58] As regards the qualification of the Funds' investments as portfolio investments in listed assets, the Respondent summarized, to the extent of her understanding, the type of investments each Fund primarily derived its value from. On the assumption that the term “portfolio investments” is more encompassing than the type of passive investments that would trigger the foreign accrual property income (FAPI) rules, the respondent asks that the Court conclude that the Funds derived their value primarily from portfolio investments in listed assets.
[59] Finally, the Respondent brought it to the Court's attention that, when Gerbro communicated in writing with the CRA in response to certain requests for information during the audit stage, Gerbro referred to the nature of the investment in each of the Funds as being “[a]sset appreciation through portfolio investments”.[57] In cross-examination Ms. Gut stated that Gerbro's characterization likely mirrored words used in the Funds' offering memoranda and that she understood “portfolio investment” to mean a group of investments.[58]
3 APPLICABLE LAW [60] Section 94.1 of the ITA is the applicable provision in the case at bar, and it reads as follows:
94.1(1) If in a taxation year a taxpayer holds or has an interest in property (referred to in this section as an “offshore investment fund property”)
(a) that is a share of the capital stock of, an interest in, or a debt of, a non-resident entity (other than a controlled foreign affiliate of the taxpayer or a prescribed non-resident entity) or an interest in or a right or option to acquire such a share, interest or debt, and
(b) that may reasonably be considered to derive its value, directly or indirectly, primarily from portfolio investments of that or any other non-resident entity in
(i) shares of the capital stock of one or more corporations,
(ii) indebtedness or annuities,
(iii) interests in one or more corporations, trusts, partnerships, organizations, funds or entities,
(iv) commodities,
(v) real estate,
(vi) Canadian or foreign resource properties,
(vii) currency of a country other than Canada,
(viii) rights or options to acquire or dispose of any of the foregoing, or
(ix) any combination of the foregoing,
and it may reasonably be concluded, having regard to all the circumstances, including
(c) the nature, organization and operation of any non-resident entity and the form of, and the terms and conditions governing, the taxpayer’s interest in, or connection with, any non-resident entity,
(d) the extent to which any income, profits and gains that may reasonably be considered to be earned or accrued, whether directly or indirectly, for the benefit of any non-resident entity are subject to an income or profits tax that is significantly less than the income tax that would be applicable to such income, profits and gains if they were earned directly by the taxpayer, and
(e) the extent to which the income, profits and gains of any non-resident entity for any fiscal period are distributed in that or the immediately following fiscal period,
that one of the main reasons for the taxpayer acquiring, holding or having the interest in such property was to derive a benefit from portfolio investments in assets described in any of subparagraphs 94.1(1)(b)(i) to 94.1(1)(b)(ix) in such a manner that the taxes, if any, on the income, profits and gains from such assets for any particular year are significantly less than the tax that would have been applicable under this Part if the income, profits and gains had been earned directly by the taxpayer, there shall be included in computing the taxpayer’s income for the year the amount, if any, by which
(f) the total of all amounts each of which is the product obtained when
(i) the designated cost to the taxpayer of the offshore investment fund property at the end of a month in the year
is multiplied by
(ii) 1/12 of the total of
(A) the prescribed rate of interest for the period that includes that month, and
(B) two per cent
exceeds
(g) the taxpayer’s income for the year (other than a capital gain) from the offshore investment fund property determined without reference to this subsection.
4 ISSUES [61] The first issue in this appeal is whether the Funds derived their value, either directly or indirectly, primarily from “portfolio investments” in listed assets (Value Test). To answer this question the Court will define the term portfolio investment and then determine if the Funds primarily derived their value from such investments. If they did, the Court will ascertain whether the portfolio investments are investments in assets listed in subparagraphs 94.1(1)(b)(i) to (ix).
[62] The second issue is whether it may reasonably be concluded, having regard to all the circumstances, including those mentioned in paragraphs 94.1(1)(c) to (e), that one of Gerbro's main reasons for investing in the Funds was to pay less tax than would have been payable under Part I of the ITA if the portfolio investment had been held directly (Motive Test).
[63] In its Amended Notice of Appeal, the Appellant disagreed as to the calculation of the imputed income in the event that the Court should conclude that both the Value Test and the Motive Test have been met. However, this question was not argued before me in either the written submissions or in open court. I therefore conclude that this last point is no longer at issue.
[64] Before dissecting each issue, I will first address the question of the burden of proof with respect to the respondent's assumptions of mixed fact and law. I will then give an overview of the foreign affiliate regime, section 94.1 and the proposed FIE Rules, which were never adopted.
5 ANALYSIS 5.1 Preliminary Remarks: Respondent's Assumptions of Mixed Fact and Law [65] It is trite law that in tax appeals a taxpayer has the onus of proving on a balance of probabilities that the Minister's assumptions of fact are not true, and that, absent such evidence, the assumptions will stand.[59]
[66] The assumptions of fact must be “precise and accurate so that the taxpayer knows exactly the case it has to meet”: Anchor Pointe Energy Ltd. v. Canada, 2003 FCA 294, [2003] F.C.J. No. 1045 (QL), at paragraph 23.
[67] Assumptions of law or mixed fact and law are not binding on this Court, regardless of the fact that they could have or should have been stricken from the pleadings. To hold otherwise would be to divest this Court of its power to rule on questions of law. In Kopstein et al. v. The Queen, 2010 TCC 448, 2010 DTC 1307, Justice Jorré, ruling on a motion to strike, enunciated this proposition in the following way:
[67] In assessing whether it is appropriate to strike a paragraph of a pleading one must bear in mind the practical effect of the paragraph.
[68] In this context one must bear in mind that an invalid or irrelevant assumption does not cast an onus upon an appellant just because it was pleaded. For example, if on discovery it turns out that an assumption was never made then there is no onus on the appellant to disprove it; if the respondent wishes to rely on that particular fact, the respondent will have to prove it. Similarly, if what is pleaded as an assumption of fact is simply a conclusion of law and no underlying facts for that conclusion of law have been assumed elsewhere then there is no obligation on an appellant to disprove that.
[68] Furthermore, this Court should not be required to extract the factual components from assumptions of mixed fact and law when these assumptions are incorrectly pleaded. See Anchor Pointe, supra, at paragraph 27. Properly pleading assumptions of fact is incumbent on the Respondent when drafting her reply.
[69] By order dated May 27, 2014 in the present appeals, (Gerbro Inc. v. R., 2014 TCC 179, [2014] 6 C.T.C. 2010), Woods J. denied the Appellant's motion to strike the assumptions in paragraphs 19 (ff), (zz), (ttt) and (pppp) of the Reply in respect of the 2005 taxation year, and paragraphs 14.35, 14.73 and 14.94 in the Reply in respect of the 2006 taxation year.[60] It is clear from her reasons for order that she denied the motion because of the “fresh step” rule, in section 8 of the Tax Court of Canada Rules (General Procedure). In disallowing Gerbro's motion to strike, Justice Woods enforced the policy behind the “fresh step” rule, which is to ensure that the appeal process moves forward, and not backwards as that would risk unduly prolonging the appeal process. Allowing the motion to strike would have resulted in the Crown being granted leave to amend its reply to extract the factual assumptions underlying its assumption of mixed fact and law, and that in turn would have necessitated further discovery.
[70] Justice Woods did not make any legal findings as to the effect of the inappropriate assumptions at trial. She noted that the strategy of Gerbro's counsel of waiting to bring the motion to strike might have worked against Gerbro, since it was now barred from having the assumptions struck. This does not address the matter of the effect of those assumptions at trial, which, according to Kopstein, should not have the effect of placing the onus on Gerbro. As a matter of fact, Justice Woods stated, at paragraph 31 of her order, that “[i]f it were not for the potential application of the fresh step rule, the purpose test assumptions should be struck out with leave to amend to extricate the factual elements.”
[71] The Supreme Court in Canada (Director of Investigation and Research) v. Southam Inc., [1997] 1 S.C.R. 748 distinguished questions of mixed law and fact from purely factual or legal questions with the following example:
35. . . . Briefly stated, questions of law are questions about what the correct legal test is; questions of fact are questions about what actually took place between the parties; and questions of mixed law and fact are questions about whether the facts satisfy the legal tests. A simple example will illustrate these concepts. In the law of tort, the question what “negligence” means is a question of law. The question whether the defendant did this or that is a question of fact. And, once it has been decided that the applicable standard is one of negligence, the question whether the defendant satisfied the appropriate standard of care is a question of mixed law and fact. I recognize, however, that the distinction between law on the one hand and mixed law and fact on the other is difficult. On occasion, what appears to be mixed law and fact turns out to be law or vice versa.
[Emphasis added.]
[72] Thus, it can be concluded that the assumptions in paragraphs 19 (ff), (zz), (ttt), and (pppp) of the 2005 reply are assumptions of mixed fact and law. The same is true for the assumptions in paragraphs 14.35, 14.73 and 14.94 of the 2006 reply. Justice Woods pointed out the existence of at least two legal questions in the Minister's assumptions, namely: “What is a portfolio investment?" and "When do tax considerations satisfy the purpose test?” (Gerbro, supra, at paragraph 30.) I agree.
[73] The Respondent must now cope with assumptions of mixed fact and law in her reply that are for all intents and purposes ineffective in placing on the Appellant the burden of proving that its investments in the Funds were portfolio investments or that the Motive Test was met. Given the analysis below, the ineffective assumptions are of no consequence.
5.2 The Mischief the OIFP Rules Sought to Resolve 5.2.1 Historical and Statutory Overview of the Foreign Affiliate Regime [74] The foreign affiliate rules in Division B, subdivision i of Part I of the ITA existed for over a decade before the OIFP Rules were enacted in 1984.[61] Since their inception in 1972, the foreign affiliate rules have been modified substantially over the years, both before and after the OIFP Rules were enacted.
[75] In brief, the foreign affiliate regime is made up of two components. Those components are the current inclusion of foreign accrual property income of a controlled foreign affiliate (CFA) of a taxpayer resident in Canada (subsections 91(1) and 95(1)), and the foreign affiliate dividend regime (FA dividend regime), which deals with the taxation of dividends when they are received by Canadian residents from foreign corporations (sections 90 and 113).[62]
[76] The two components produce various tax outcomes on two main axes. Simply put, the taxation outcomes will depend on whether the foreign corporation in which the interest is held is a foreign affiliate or a CFA,[63] and whether the income earned is active or passive. The FAPI rules apply when a controlled foreign affiliate earns FAPI (passive investment income, such as interest, rent, royalties or dividends.) The FA dividend rules apply as long as the foreign corporation is a foreign affiliate, not necessarily controlled by Canadian residents.[64] A CFA, on the other hand, will have to determine, with regard to passive income, if it has FAPI,