Quebec Revenue Agency Challenges a Repo Transaction: Kone Inc.

Background

In the Kone case (Kone inc. c. Agence du revenu du Québec, 2022 QCCQ 9892), a corporation resident in Canada (CRIC) that was ultimately owned by a Finnish group implemented a classic repo transaction to facilitate the acquisition of a US group by the Canadian operating entity of the group, Kone Inc. The taxation years that were assessed by the Agence du revenue du Québec (ARQ) were 1999 to 2006.

A repo is a hybrid transaction in which a Canadian company finances a US group with preferred shares that have a fixed dividend entitlement. The dividends received on the shares are deductible under paragraph 113(1)(a) to the extent that they are paid from the exempt surplus account. As a result of various agreements concluded between Canadian and US entities (forward and support agreements), the arrangement is considered debt for US income tax purposes. As noted in the Kone case, the United States applies a substance-over-form tax doctrine in recharacterizing the arrangement as debt. Thus, the dividends are considered interest for the purposes of the Internal Revenue Code (IRC) and are deductible in computing US taxable income.

To the extent that a CRIC, pursuant to paragraph 20(1)(c), incurs deductible interest expense to make an investment in a US acquisition, a significant tax benefit is obtained, because the taxpayer obtains an interest deduction for an investment that generates a non-taxable dividend.

ARQ’s Position

The ARQ challenged the repo transaction on the basis of the following:

• The Quebec equivalent of section 17 (that is, article 127.6 of the Quebec Taxation Act [QTA]) applied to the transaction. Essentially, the ARQ’s view was that (1) the arrangement was in substance—or on the basis of the “sham” doctrine (“trompe-l’oeil,” “simulacre,” or an “acte simulé” under article 1451 of the Civil Code of Québec)—an interest-free loan (IFL) to Kone’s US subsidiary; and (2) imputed interest should have been included in income.
• The Quebec GAAR.

The Court’s Findings

Regarding the application of the Quebec equivalent of section 17, the Quebec court held that the legal form of the transaction (that is, a preferred share investment) must be respected. Moreover, the court noted that the characterization of the transaction as a loan for US income tax purposes was not relevant, because it was based on a US substance-over-form tax doctrine.

The threshold for finding a transaction to be a sham was discussed at length by the court, which noted, in particular, that for a sham to exist, the taxpayer must have a clear and manifest intent to portray the transaction to the fisc as something different from the actual contractual relationship. The ARQ was not able to demonstrate this intention.

As for the Quebec GAAR, the court concluded that there was a tax benefit but that the benefit was not a misuse or abuse of the Act.

Observations

Taxpayers that have implemented repo transactions should be comforted by the Quebec court’s decision.

Various legislative changes have eliminated the tax-effectiveness of the repo structure. The 2017 US Tax Cut and Jobs Act modified IRC section 267A by eliminating the deduction that was obtained for US income tax purposes, thus denying benefits of the kind obtained in the Kone case. In the Canadian context, the recently proposed hybrid legislation would eliminate the benefit, too. These legislative changes are based, in large part, on the OECD and European initiatives to limit the benefits obtained from hybrid structures.

Many Canadian taxpayers did not unwind their repo structures after the US changes because the dividends on the preferred shares provided an efficient means of repatriating earnings from US subsidiaries without incurring withholding tax: the amounts paid are considered interest.

Finally, because the repo transaction was implemented by a CRIC, the foreign affiliate dumping (FAD) provisions (section 212.3) apply, with the result that this type of transaction would not be tax-efficient with respect to transactions or events after March 28, 2012.

The ARQ did not invoke the equivalent of paragraph 247(2)(b), the transfer-pricing provision that may in certain cases allow the taxation authority to recharacterize a transaction. Given the court’s findings with respect to the sham argument, it is unlikely that an argument based on the transfer-pricing recharacterization rules would have modified the ultimate result, because some of the arguments relating to sham or “simulacre” would be similar to those that would be used to support a recharacterization under a transfer-pricing analysis.

Regarding the court’s GAAR analysis, it is interesting to note that neither the ARQ nor the taxpayer appears to have mentioned the legislative changes outlined above (that is, the anti-hybrid provisions added to the IRC, the proposed Canadian anti-hybrid draft legislation, and the FAD provisions). Arguably, the taxpayer could have contended on additional grounds that these legislative changes confirm that, a priori, the repo structure should not be considered a misuse or abuse of the QTA read as a whole. Not surprisingly, the ARQ did not mention the legislative changes because this would have weakened its position vis-à-vis the Quebec GAAR.

Pierre J. Bourgeois
Raymond Chabot Grant Thornton LLP, Montreal