FLSmidth Ltd. v. The Queen: Non-Business Income Tax Deduction Denied as “Related To” a Share of a Foreign Affiliate

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FLSmidth Ltd. v. The Queen[1] (June 18, 2013) dealt with the deduction of foreign non-business income tax in the 2002 taxation year by GL&V/Dorr-Oliver Canada Inc. (Dorr-Oliver), a predecessor corporation of the appellant.  The tax structure involved is rather complex and is set out in the Tax Court judgment under appeal:

[10]         The following entities were part of the GL&V structure:

GL&V and Peg Limited Partnership – the U.S. limited partnership of which Dorr-Oliver was a member. It was constituted under the laws of the state of Delaware.[4] Dorr-Oliver had a 98.9% interest in the limited partnership, and GL&V had a 1% interest. The general partner (another wholly owned subsidiary of GL&V) held a 0.1% interest.[5] The limited partnership filed an election with the U.S. Internal Revenue Service to be treated as a U.S. resident corporation. Under Canadian tax law, the limited partnership was treated as a transparent entity.

GL&V Company: a Nova Scotia unlimited liability company (“NSULC”), all of the shares of which were owned by the limited partnership. The sole activity of the limited partnership was holding the shares of NSULC. NSULC was a disregarded entity under U.S. tax law. It was treated as a corporation under Canadian tax law and therefore subject to tax as a separate person.

GL&V Finance Inc.: a U.S. limited liability company (“LLC”) all of the shares of which were owned by NSULC. LLC was a disregarded entity under U.S. tax law. Under Canadian tax law, LLC was treated as a separate person subject to tax.

[11]         GL&V used the cross-border structure to finance the its acquisition of U.S. companies in the following manner:

– the limited partnership subscribed for shares of NSULC using, in part, borrowed funds;

– NSULC used the funds from the subscriptions made by the limited partnership to subscribe for shares of LLC;

– LLC used the proceeds from the subscriptions to make interest‑bearing loans (the “LLC loans”) to GL&V Holdings (“Holdings”), a U.S. subsidiary of GL&V, and

– Holdings used the proceeds of the LLC loans to provide capital and loans to indirectly wholly-owned subsidiaries of GL&V to purchase U.S. companies.

[12]         For the year ended March 31, 2002, LLC earned interest income from Holdings on the LLC loans and used this income as well as interest income it earned in the previous year to pay dividends to NSULC. NSULC used the proceeds of the dividends from LLC to pay dividends to the limited partnership.

[13]          During that year, the limited partnership paid interest on money it borrowed to subscribe for the NSULC shares.

[14]         These transactions gave rise to different tax results under U.S. and Canadian tax law.

[15]         For U.S. tax purposes NSULC and LLC were treated as disregarded entities, and it was considered that:

-the limited partnership made the LLC loans to Holdings directly,

-the interest earned on those loans was earned directly by the limited partnership, and the LLC dividends and the NSULC dividends were disregarded, and

-the interest paid by the limited partnership on the money used to acquire the NSULC shares and ultimately fund the LLC loans was incurred to earn the interest income on the LLC loans.

The limited partnership filed an election with the U.S. Internal Revenue Service to be treated as a U.S. resident corporation. In computing its net income, it included the interest income from Holdings, and it deducted the interest it paid on the money it borrowed to purchase the NSULC shares. The limited partnership paid tax to the U.S. government on the resulting net income.

[Emphasis added]

The key point here is that the U.S. tax was paid by the limited partnership of which the appellant’s predecessor was a limited partner.  The ultimate source of the partnership income was dividends paid by LLC to NSULC and then by NSULC to the limited partnership.

There was only one issue before the court in this appeal:[2]

– Can Dorr-Oliver’s share of the U.S. tax paid by the GL&V limited partnership be reasonably regarded as having been paid in respect of income from a share of the capital stock of a foreign affiliate, i.e. LLC?

In a nutshell then the question was whether the interposition of the limited partnership and NSULC between the taxpayer and LLC was sufficient to permit the deduction of foreign non-business income tax or whether the deduction of that tax was still prohibited by the language of subsection 20(12) of the Act:

In computing a taxpayer’s income for a taxation year from a business or property, there may be deducted such amount as the taxpayer claims not exceeding the non-business income tax paid by the taxpayer for the year to the government of a country other than Canada (within the meaning assigned by subsection 126(7) read without reference to paragraphs (c) and (e) of the definition “non-business-income tax” in that subsection) in respect of that income, other than such tax, or part thereof, that can reasonably be regarded as having been paid by a corporation in respect of income from a share of the capital stock of a foreign affiliate of the corporation.

[Emphasis added]

since, under either structure, LCC was a foreign affiliate of the taxpayer.

The Tax Court dismissed the taxpayer’s appeal and the Federal Court of Appeal dismissed the taxpayer’s appeal from that decision.

The gist of the Federal Court of Appeal’s decision here appears to be that the use of the phrase “in respect of” twice in subsection 20(12) is sufficient to permit a tracing of the ultimate source of the income to LCC:

[33]           The appellant does not take issue with the construction given by the Tax Court judge to the phrase “in respect of” as it twice appears in subsection 20(12). The focus of the appeal is on the words “can reasonably be regarded” which qualify the second condition. According to the appellant, the Tax Court judge failed to give effect to these words in holding that the second condition had not been met (memorandum of the appellant, paras. 11 and 22 to 28). According to the appellant (memorandum of the appellant, para. 29):

Had the [Tax Court judge] carefully reviewed the meaning and function of the expression “can reasonably be regarded” …, he would not have expanded their scope to such an extent that now allow the consideration of other taxpayer’s income irrespective of legal substance. There is simply no reason to believe that the expression “can reasonably be regarded” acquires a distinct meaning in subsection 20(12) or that, absent specific wording, Parliament authorized a tracing approach. …

[My emphasis]

[34]           The difficulty with this argument is that the Tax Court judge’s conclusion on the second condition is not based on an expanded view of the words “can reasonably be regarded” (reasons, para. 65):

… I conclude that … the U.S. tax … were paid in respect of income from the shares of LLC and that the tax could therefore reasonably be regarded as having been so paid.

[My emphasis]

[35]           It can be seen that this conclusion rests entirely on the broad meaning which the Tax Court judge gave to the phrase “in respect of”. This should be obvious given the fact that he construed the phrase the exact same way in dealing with the first condition even though it does not embody the words “can reasonably be regarded”. As with the first condition, the Tax Court judge was satisfied that the tax sought to be deducted was “related to or connected with” the dividend income received by NSULC from LLC since both were part of the flow of funds that originated with Holdings and ended up with the GL&V limited partnership (reasons, paras. 46 and 58). Hence the U.S. tax was connected or related to both the NSULC shares and the LLC shares.

The court also rejected an economic argument made by the taxpayer:

[41]           The argument made with respect to the first condition before the Tax Court judge is that while the “economic profit” from the NSULC dividend was reduced by the U.S. tax, the “economic profit” from the LLC dividend was not (appendix A to the appellant’s memorandum, paras. 1 to 7). The essence of this argument is that (idem, para. 2):

… The concept of income, ultimately a legal determination refers to an economic reality based on a net accretion (or gain) from a source. If taxes reduce the economic profit from that source, it is reasonable to conclude that those taxes are paid “in respect of” income from that source.

[My emphasis]

[42]           The notion that a dividend can be viewed as a “profit” from a share is foreign to the Act. A dividend is included in income, not on the basis of a computation of profit from property in accordance with the relevant accounting principles and statutory rules (subsection 9(1)), but by reason of the specific inclusion provided by subdivisions b and i – Income or Loss from a Business or Property and Shareholders of Non Resident Corporations – specifically paragraphs 12(1)(j), (k) and subsection 90(1). In this case, it is the whole of the dividend that was included in income in accordance with these provisions before being deducted pursuant to subsection 112(1), and the use made of that income after it has been so included does not have the effect of reducing it.

This decision, unless it is reversed by the Supreme Court of Canada, will likely cause the tax community to re-examine a number of cross-border lending strategies.

[1] 2013 FCA 160.

[2] Id, para. 16 in conjunction with para. 26.