The Court found that section 245 (GAAR) of the Canadian Income Tax Act did not apply to the transactions in question.
Subsection 245(1) defines a “tax benefit” as a reduction, avoidance or deferral of tax. The Respondent says that the tax benefit BMO received was the reduction in its tax payable as a result of subsection 112(3.1) not applying to reduce its share of the capital loss on the disposition of the common shares of NSULC.
In 2005, the Bank of Montreal (“BMO”) wanted to lend a total of $1.4 billion USD to a number of its US subsidiaries referred to as the Harris Group. BMO chose to borrow those funds from third parties.
It would not have been tax efficient for BMO to simply borrow the funds and lend them to the Harris Group. Such a structure would have resulted in BMO having to pay US withholding tax on the interest payments it received from the Harris Group. As a result, BMO implemented what is commonly referred to as a “tower structure”. A tower structure is a complicated structure often used by Canadian companies to finance US subsidiaries in a tax efficient manner. It allows the deduction of interest costs by the Canadian company for Canadian tax purposes and the deduction of the corresponding interest costs by the US subsidiary for US tax purposes without having to pay withholding tax to the US on the repatriation of the funds.
The tower structure implemented by BMO consisted of the following entities:
(a) a Nevada limited partnership named BMO Funding L.P. (“Funding LP”) in which BMO had a 99.9% interest and a wholly owned subsidiary of BMO named BMO G.P. Inc. (“BMO GP”) had a 0.1% interest;
(b) a Nova Scotia unlimited liability company named BMO (NS) Investment Company (“NSULC”) that was wholly owned by Funding LP; and
(c) a Delaware limited liability company named BMO (US) Funding LLC (“LLC”) that was wholly owned by NSULC.
BMO borrowed $150 million USD from a third party. It invested those funds in Funding LP. Funding LP, in turn, used those funds to acquire shares of NSULC which, in turn, used those funds to acquire shares in LLC. LLC then took the funds that it had received and lent them to the Harris Group.
The balance of the required $1.4 billion USD came from a $1.25 billion USD loan obtained by Funding LP from a third party. Again, Funding LP used those funds to acquire shares of NSULC which, in turn, used those funds to acquire shares in LLC. LLC then took the funds that it had received and lent them to the Harris Group.
Interest payments and dividends flowed through the tower structure at the end of each fiscal quarter. The Harris Group would pay interest to LLC. LLC would then use the money to pay dividends to NSULC. NSULC would pay corresponding dividends to Funding LP. Funding LP would use the funds it received to pay interest on the $1.25 billion USD that it had borrowed and would distribute the balance to BMO and BMO GP. BMO would, in turn, use the funds it received from Funding LP to pay interest on the $150 million USD that it had borrowed.
The dividends received by BMO from NSULC (indirectly through Funding LP) were taxable dividends. BMO benefited from a subsection 112(1) deduction in respect of those dividends.
From a business point of view, by borrowing US dollars to make an investment in a US asset, BMO effectively hedged its foreign exchange risk. If the Canadian dollar decreased in value against the US dollar between 2005 and 2010, then the increase in value (in Canadian dollars) of BMO’s indirect US dollar investment in the Harris Group would be matched by the increased cost (in Canadian dollars) of repaying the $1.4 billion USD in borrowed funds. Conversely, if the Canadian dollar increased in value against the US dollar between 2005 and 2010, then the decrease in value (in Canadian dollars) of BMO’s indirect US dollar investment in the Harris Group would be matched by the decreased cost (in Canadian dollars) of repaying the $1.4 billion USD in borrowed funds.
However, from a tax point of view, BMO faced a potential problem with hedging its foreign exchange risk. There would not be any problem if the Canadian dollar decreased in value. Any increase in the value of the NSULC shares held by Funding LP that arose from a decrease in the value of the Canadian dollar would be taxable as a capital gain. That capital gain would be offset by the corresponding capital loss that would arise on the repayment of the $1.4 billion USD in borrowed funds. On the other hand, BMO would have a problem if the Canadian dollar increased in value. The resulting decrease in the value of the NSULC shares held by Funding LP would give rise to a capital loss. However, the stop-loss rule in subsection 112(3.1) would reduce that capital loss by an amount equal to the value of any non-taxable dividends that Funding LP had received from NSULC. As a result, the reduced capital loss would not be sufficient to fully offset the capital gain that would arise on the repayment of the $1.4 billion USD in borrowed funds.
To avoid this potential mismatch of the capital gain and capital loss, BMO implemented a modification to the tower structure. Subsection 112(3.1) applies separately to each class of shares. Therefore, BMO decided to create a structure whereby NSULC had two classes of shares. When the first set of quarterly dividends was being paid, instead of paying a cash dividend, NSULC paid a stock dividend consisting of preferred shares. This resulted in Funding LP holding two classes of shares of NSULC: common shares with a high cost base and preferred shares with a low cost base. From that point forward, all quarterly dividends were paid on the preferred shares. By isolating the dividends in this manner, BMO ensured that, if the Canadian dollar increased in value resulting in a capital loss on the common shares of NSULC, the loss would not be ground by the value of the non-taxable dividends that had been paid by NSULC and thus the loss would fully offset the capital gain on the borrowed funds.
BMO’s planning proved fortuitous. The Canadian dollar increased in value significantly between 2005 and 2010.  The use of the two-class structure ensured that the capital loss on the disposition of the shares of NSULC matched the capital gain on the borrowed funds.
The tower structure was unwound in 2010. The Harris Group repaid the loans made by LLC. LLC was wound up and its assets were distributed to NSULC. NSULC, in turn, was wound up and its assets were distributed to Funding LP. Funding LP used the funds it received to repay the $1.25 billion USD that it had borrowed. It distributed the balance of the funds to BMO and BMO GP. BMO used the funds it received from Funding LP to repay the $150 million USD that it had borrowed.
The Canadian tax authorities concluded that, while the resulting structure technically complied with the Act, the GAAR should be used to reduce BMO’s share of the capital loss on the disposition of the common shares of NSULC by the amount by which the loss would have been ground under subsection 112(3.1) had BMO not modified the structure. Accordingly, the Minister reassessed BMO to reduce its capital loss by $287,766,503.
The Tax Court concluded that BMO did not receive a tax benefit, and therefore there was no need to consider whether there was an abuse of subsection 112(3.1).Canada vs Bank of Montreal Dec 2018 TCC 187