Repo Transactions Are Not Loans ' A Reminder That Legal Substance Prevails In Canada (For Now)

• Law Firm: McCarthy Tétrault LLP
• Subject Matter: Tax, Income Tax, Tax Authorities
• Author: Tax Perspectives, Dominic Bédard-Lapointe and Stephanie Dewey
• Published date: 16 March 2023

The Quebec Court decision in Kone Inc. v. QRA¹ reiterates that economic substance has limited impact in the Canadian tax landscape, including for the purposes of the General Anti-Avoidance Rule ("GAAR"). Repo transactions cannot be recharacterized as a loan for Canadian tax purposes simply because such an arrangement presents similar features.²Kone represents a good preview to assess how the GAAR framework could be impacted should the Department of Finance decide to incorporate an economic substance element into the abuse analysis, as currently contemplated.

Facts

The taxation years in issue are 1999 to 2006. In order to finance upcoming acquisitions, a Canadian entity part of an international group issued $400,000,000 in notes.³ Pursuant to the group's financing strategy, those funds were ultimately made available to a foreign affiliate that would complete the acquisitions.⁴ For that purpose, instead of making further intra-group loans, repo transactions were entered into whereby newly issued preferred shares of another foreign affiliate in the group were purchased by an operating Canadian entity, subject to a repurchase agreement. The shares were in fact repurchased a few years later, for the same consideration plus all undeclared cumulative dividends accrued in respect of such shares.⁵ The resulting gain was deemed to be a dividend paid out of exempt surplus,⁶ such that there was no tax.

The QRA took offence with the fact that the repo transactions "were equivalent to loans", and were treated as such for US tax purposes. In the US, the payment of the cumulative dividends on the preferred shares gave rise to a deduction (they were treated as interest, based on the repo's economic substance). The transaction was challenged both on the basis of sham and GAAR.

The Decision

Sham requires an intent to deceive the tax authorities.⁷ For Canadian tax purposes, the absence of economic substance (other than obtaining a tax benefit) does not amount to a sham.⁸ In light thereof, the Court concluded that the repo transactions were designed and documented precisely to obtain the intended tax result.⁹ The fact that the transactions were intended to be recharacterized as a loan for US tax purposes pursuant to the US "substance over form" doctrine did not impact the Court's conclusion on sham, or determination of the legal effect of the transactions.¹⁰

In respect of the GAAR analysis, the Court concluded that there was no abuse of the Quebec equivalent to section 17...