Offshore Investment Fund Property Rules Clarified by the Tax Court

The recent decision of the Tax Court of Canada in Gerbro Holdings Company v. The Queen ("Gerbro")1 is the first judgment to consider the application of the offshore investment fund property rules (the "OIFP Rules") contained in section 94.1 of the Income Tax Act (Canada) (the "Tax Act") to interests in investment funds based in what have traditionally been viewed as "tax-havens".2 The decision, a win for the taxpayer, held that tax considerations were not "one of the main reasons" motivating the taxpayer to invest in, and hold shares of, the offshore investment funds at issue. Therefore, the OIFP Rules were found not to apply to the taxpayer.

Background

The OIFP Rules are anti-avoidance rules intended to discourage taxpayers from investing in investment funds situated outside of Canada in order to reduce or defer their liabilities for Canadian tax. In highly simplified terms, the OIFP Rules apply where:

a taxpayer acquires an interest ("Offshore Property") in a foreign entity (other than a "controlled foreign affiliate"), the investment can reasonably be considered to derive its value, directly or indirectly, principally from certain "portfolio investments" of the foreign entity (or any other non-resident person) (the "Portfolio Test"), and it may reasonable be concluded that one of the main reasons for the taxpayer investing in the Offshore Property was to derive a benefit from portfolio investments in such a manner that the taxes, if any, on the income, profits and gains from such portfolio investments for any particular year are significantly less than the tax that would have been payable under Part I of the Tax Act if the income, profit and gains had been earned directly by the taxpayer (the "Motive Test"). Where the OIFP Rules apply in respect of a taxpayer's Offshore Property, the taxpayer is essentially required to include an amount in its income equal to the product of the deemed cost of the Offshore Property multiplied by a specified interest rate (currently, a prescribed interest rate3 plus 2%), less any amount of income (but not capital gains) otherwise recognized by the taxpayer from the Offshore Property. This deemed income accrual gets added to the tax cost of the Offshore Property. The effect of this income inclusion is two-fold: it accelerates the recognition of income in respect of the Offshore Property, and it converts some gains that would otherwise be treated as capital gains (only half of which are subject to tax) into ordinary income.

The Gerbro Case

In Gerbro, the taxpayer, Gerbro Holdings Company ("GHC"), was a holding company that was wholly owned by a spousal trust established for the benefit of Marjorie Bronfman (the "Spousal Trust"). GHC was tasked with investing the capital and income of the Spousal Trust during...