Hedge Fund Investments Survive Section 94.1 Challenge

Although based in low-tax jurisdictions, Tax Court finds business reasons for investments overshadowed their tax benefits.

Section 94.1 of the Income Tax Act (Canada) is an anti-avoidance rule aimed at attempts to divert investment income to an offshore entity in a low (or no) tax jurisdiction. In Gerbro Holdings Company v. The Queen 1, the Tax Court of Canada considered, for the first time, the application of this rule to investments in offshore hedge funds.2The Court concluded that the underlying assets of such funds may be "portfolio investments" for purposes of section 94.1, but the section did not apply in Gerbro because none of the main reasons for investing in the hedge funds was to defer or avoid Canadian taxes.

Section 94.1

Section 94.1 requires a deemed income inclusion where a Canadian investor has an interest in a non-resident entity, and two conditions are met:

the interest in the entity derives its value primarily from "portfolio investments" in specified properties (including shares, debt, commodities, real estate and currencies) (the Value Test) and it may reasonably be considered that one of the main reasons for investing in the entity is to significantly reduce the taxes that would have been applicable if the income from such investments had been earned directly (the Motive Test). Section 94.1 was introduced in 1984 in response to the marketing of offshore mutual funds as vehicles to earn passive income tax-free.3 Although successful in shutting down the "interest roll-up" funds it targeted, section 94.1 was criticized for its arbitrary income inclusion, uncertainty surrounding the term "portfolio investments," and (by the tax authorities) for the challenges of establishing that an investment is tax-motivated. Nearly 10 years of proposals to amend section 94.1 (and recast it as a capital export neutrality measure, applicable to any low-tax jurisdiction investment) were abandoned in 2010 as too complex; instead, the amount of the deemed income inclusion was increased and, except for changes to its administration (reassessment period, reporting obligations), section 94.1, with its unresolved issues, remains otherwise unchanged.

The Gerbro hedge fund investments

Gerbro Holdings Company was a holding company responsible for investing the assets of its sole shareholder, a Canadian spousal trust, during the beneficiary's lifetime. In 2005, Gerbro began adding investments in five large offshore hedge funds to its more traditional...