Crafty Declaratory Relief Denied

In Kraft Heinz Canada ULC (2022 BCSC 796), the taxpayer, Kraft Canada, sought an order from the BC Supreme Court declaring that steps taken to reverse a capital contribution to a Dutch subsidiary under Dutch law rendered the transaction void ab initio. In the alternative, the taxpayer sought an order rescinding the transaction. This case raises questions about how remedies under foreign law to fix unintended tax consequences should be treated for Canadian tax purposes.

By way of background, in September 2020, Kraft Canada made a capital contribution of $66.49 million to its subsidiary, H.J. Heinz Investments Coöperatief U.A. (“Heinz Co-op”), under a capital contribution agreement. The agreement provided that its terms would be governed by Dutch law and that any dispute thereunder would be submitted exclusively to a Dutch court. In his reasons, Gomery J accepted that the capital contribution was made for “accounting reasons” and that the parties had proceeded on the basis of an internal tax adviser’s advice that the capital contribution would be tax-neutral from a Canadian tax perspective. In early 2021, the same tax adviser realized that the transaction fell squarely into the foreign affiliate dumping rules in section 212.3 of the Income Tax Act (Canada): Kraft Canada was a corporation resident in Canada, controlled by a US-resident corporation, and the capital contribution was an “investment” in Kraft Canada’s foreign affiliate, Heinz Co-op; consequently, Kraft Canada was deemed by subsection 212.3(2) to have paid to its US parent a dividend subject to part XIII withholding tax. Gomery J accepted that the parties would not have proceeded with the capital contribution had they been aware of the adverse tax consequences under the foreign affiliate dumping rules.

Later in 2021, after seeking advice in Canada and the Netherlands, Kraft Canada and Heinz Co-op entered into a “Declaration of Annulment Capital Contribution Agreement,” with the intention of annulling the capital contribution with retroactive effect, and Heinz Co-op returned the $66.49 million to Kraft Canada. Again, the annulment declaration provided that its terms were governed by Dutch law. Kraft Canada presented expert evidence from a Dutch lawyer who, citing a specific provision in the Dutch Civil Code, concluded that under Dutch law the annulment of the capital contribution agreement had retroactive effect to the time the original agreement was entered into, which meant that Kraft Canada had no obligation to make the contribution and could reclaim the funds from Heinz Co-op.

Gomery J first addressed Kraft Canada’s request for a declaration, under Supreme Court Civil Rule 20-4, that the capital contribution was void ab initio in accordance with the annulment declaration, with retroactive effect to September 2020, and that the annulment declaration was valid and enforceable. Gomery J began by questioning the need for such a declaration; he stated at paragraph 21 that “[t]here is no obvious reason not to apply Dutch law to the parties’ subsequent modification of the transaction, as the parties intended,” and then held that declaratory relief was not available in the absence of a live dispute and that, in this case, there was no dispute because no assessment had yet been issued by the CRA.

Next, Gomery J considered Kraft Canada’s request for an order rescinding the capital contribution. He acknowledged that the availability of rescission in the context of unintended tax consequences is controversial and that he did not have the benefit of the SCC’s decision in Collins Family Trust (2022 SCC 26) (which was released in June 2022, one month after the decision in Kraft). Notwithstanding the government’s request that Gomery J reserve judgment on rescission until Collins Family Trust had been decided, he proceeded to consider the availability of rescission, on the assumption that rescission was available as a matter of law. Again, he dismissed Kraft Canada’s request, citing a number of reasons. In his reasons, he questioned the practical effect of a rescission order in the circumstances, assuming that the transaction had already been annulled under Dutch law.

The decision in Kraft raises issues similar to those in Canadian Forest Navigation (2017 FCA 39; rev’g 2016 TCC 43), in which the taxpayer appealed the TCC’s finding that rectification orders issued by two foreign courts would need to be homologated (that is, approved or adopted) by a Quebec court in order to bind the minister of national revenue. (The core issue in that case was whether certain advances of funds should be treated as dividends despite foreign court orders rectifying the advances as loans.) That is, how should remedies under foreign law that purport to rectify or reverse transactions governed by that foreign law be regarded in determining the Canadian tax consequences of a particular transaction?

It is settled Canadian law that the characterization of a transaction governed by foreign law is a question of fact to be determined by the Canadian court on the basis of the evidence presented, which generally includes opinions of legal professionals in the foreign jurisdiction. What is less settled is whether, under the accessory principle (see The Queen v. Langueux & Frères, 74 DTC 6569 (FCTD), among other cases), if the Canadian court finds as a matter of fact that a remedy under foreign law recharacterizes or reverses a transaction governed by foreign law, Canadian tax law should be applied accordingly. In the context of Kraft, this question takes the following form: If the annulment declaration completely nullifies the capital contribution under Dutch law, should there be (under Canadian law) no investment under subsection 212.3(1) of the Act, such that no deemed dividend arises under subsection 212.3(2)? Or is a more nuanced approach appropriate, perhaps one modelled on the two-step approach to classifying foreign entities and transactions for Canadian tax purposes. That approach is as follows: (1) determine the characteristics under foreign commercial law; and (2) compare characteristics recognized under foreign commercial law with those recognized under Canadian commercial law in order to classify the entity or transaction according to one of the Canadian concepts.

Under this alternative approach, step 1 might be to determine the characteristics of the particular remedy under foreign law; then, in step 2, compare the characteristics of the remedy with remedies under Canadian law to determine how the remedy might modify the characterization of the original transaction; and finally, in step 3, in accordance with the accessory principle, apply Canadian tax statutory provisions on the basis of that legal characterization.

Under this approach, the annulment declaration in Kraft sits somewhere between a private modification agreement (given that it was essentially an agreement between the affected parties) and a rescission order (given the purported effect of nullifying the capital contribution under Dutch law). It seems improper under step 2 merely to assess whether the parties could have hypothetically satisfied the conditions for rectification in Fairmont Hotels (2016 SCC 56) or rescission in Collins Family Trust, given that no court order was sought because of the statutory “self-help” remedy under the Dutch Civil Code. The better approach, arguably, would be to assess under step 1 the legal effect of the remedy under foreign law (to assess, for example, whether it had retroactive effect, or whether it would be binding on third parties under foreign law) and then to compare the effect of the particular remedy under foreign law with the effect of similar remedies recognized in Canada, such as rectification or rescission, or statutory remedies (for example, section 229 of the BC Business Corporations Act); or to assess whether the remedy is more analogous to modification agreements between the affected parties, which generally neither are binding on third parties nor have the effect of annulling a transaction (see, for example, Sussex Square Apartments Limited v. The Queen, 99 DTC 443 (TCC)). Then it could be assessed whether the effect of that remedy would be sufficient to alter the characterization of, or to nullify, the original transaction for the purposes of applying Canadian tax rules.

As with many things, we will have to wait and see, and I, for one (in my not-so-corner office), will hold out hope that form will prevail.

Kim Maguire
Osler Hoskin & Harcourt LLP, Vancouver