Gerbro Inc. v. The Queen: Clarifying The Landscape For Canadians Investing In Offshore Hedge Funds

On July 22, 2016, the Tax Court of Canada released its highly anticipated decision in Gerbro v. R1 dealing with the offshore investment fund property rules in section 94.1 of the Income Tax Act ("OIFP Rules"). The decision is helpful in clarifying the tax consequences for Canadians who invest, or are contemplating investing, in hedge funds located in low-tax jurisdictions. The hedge fund investments at issue in Gerbro were investments in offshore funds in which the investor or related persons held less than a 10% interest.

Gerbro Inc. ("Gerbro"), a holding company of a wealthy Canadian family, invested in three hedge funds (Raptor, Kingdon and Caxton) and two funds of funds (Hausmann and Arden) to complement its other investments. Gerbro's investment portfolio was well diversified and included fixed-income, segregated funds of long-equity and hedge funds. Its investment goals and strategy were determined in advance and were set out in detailed investment guidelines approved by its board of directors. The CRA assessed Gerbro for more than $1.5M of imputed income under the OIFP Rules for its 2005 and 2006 taxation years. The Tax Court of Canada allowed Gerbro's appeal and quashed the assessments, finding that Gerbro had an "overarching bona fide commercial reason for investing" in the funds.2

The OIFP Rules apply where a Canadian taxpayer invests in a non-resident entity (e.g., an offshore feeder of a hedge fund), which (i) primarily derives its value from portfolio investments in a broad list of assets mentioned in section 94.1 (the "Asset Test"), and (ii) where one of the main reasons for making the investment in the fund was to obtain a tax benefit (the "Motive Test"). A tax benefit includes deferral of Canadian income tax to the time when the shares in the fund are redeemed. Paragraphs 94.1(1)(c) to (e) list factors to be considered, such as the nature of the non-resident entity, the amount of tax paid by such entity and the amount of dividends the entity pays. The factors listed are not exhaustive. When the OIFP Rules apply, a Canadian investor will be required to pay taxes on a notional amount of 2% plus the prescribed rate of interest (currently 1%) applied to the adjusted cost of the investment, even if the fund does not distribute any income in the particular year, or is in a loss position.3 The imputed amount will be net of any actual income the investor receives from the fund (other than capital gains) and will be added to the cost...