Kone Inc. v. ARQ, 2022 QCCQ 9892, aff'd 2024 QCCA 678

The taxpayer (“KQI”), which was a Canadian operating subsidiary in a group ultimately controlled by a Finnish parent, used funds that had been borrowed by a Canadian holding company in the group and advanced to KQI as an interest-bearing loan and subscription proceeds to purchase, for a cash purchase price of $394 million, cumulative preferred shares of “Kone USA” (a group company with an active business) from the non-resident affiliated company (“Kone BV”) to which such shares had recently been issued as a stock dividend. At the same time, KQI agreed to resell such preferred shares at pre-agreed higher prices, to Kone BV in three and five years’ time, which in fact occurred. The gain arising under this resale was deemed under s. 93 to be dividends coming out of exempt surplus of Kone USA. The funds so received by Kone BV were used indirectly to fund purchases by the Kone group of targets with complementary businesses.

The ARQ sought to impute interest income to KQI under TA s. 127.6, the Quebec equivalent of ITA s. 17(1), on the basis that the above “repo” transaction was a sham that should instead be characterized as an interest-free loan by KQI to Kone BV or, alternatively, that the repo transaction represented an abusive avoidance of such s. 17 equivalent for Quebec GAAR purposes.

In rejecting the sham argument, Fournier JCQ noted that although the parties had agreed to treat the repo transaction as a secured loan by KQI to Kone BV for U.S. tax purposes, such characterization under the US “substance over form” tax doctrine did not detract from the “actual legal obligations agreed to between the parties in Canada and Quebec” (TaxInterpretations translation, para. 131), and here the Court was in the “presence, in the United States, as in Canada, of a purchase and a sale of shares” (para. 133).

The taxpayer (“KQI”), which was a resident Canadian corporation engaged in an elevator and escalator installation and repair business and which was an indirect subsidiary of a Finnish corporation (“Kone Corporation”) assisted in the financing of the acquisition by the Kone group in 2001 of two targets with complementary businesses by using money lent to it at interest (and advanced to it as share subscription proceeds) by another group corporation (whose Canadian parent had borrowed such funds in the European mid-term note market) to purchase, for a cash purchase price of $394 million, cumulative preferred shares of “Kone USA” (a group company with an active business) from the non-resident affiliated company (“Kone BV”) to which such shares had recently been issued as a stock dividend. At the same time, KQI agreed to resell such preferred shares in two tranches, and at pre-agreed higher prices, to Kone BV in three and five years’ time, which in fact occurred. The gain arising under this resale was deemed to be a dividend under the Quebec equivalent of ITA s. 93 which, along with the cumulative dividends received in the interim, came out of exempt surplus of Kone USA. The funds so received by Kone BV were used indirectly to fund the target purchases.

The ARQ sought to impute interest income to KQI under TA s. 127.6, the Quebec equivalent of ITA s. 17(1), on the basis that the above “repo” transaction was a sham that should instead be characterized as an interest-free loan by KQI to Kone BV or, alternatively, that the repo transaction represented an abusive avoidance of such s. 17 equivalent for Quebec GAAR purposes.

After rejecting the sham argument, Fournier JCQ went on to reject the application of the Quebec GAAR. He first found that the above repo transaction gave rise to a tax benefit and a tax avoidance transaction (noting, in the latter regard, at para. 181, TaxInterpretations translation) that “KQI served only as an instrument utilized by Kone Corporation to thus permit the acquisition of the Targets by way of a financing which was required to be the most advantageous possible from a tax viewpoint.”

However, in finding that the required element of abuse of the s. 17-equivalent rule had not been established, he noted (at para. 196) that such rule “contemplated blocking the exporting of income and preventing Canadian corporations from using their capital outside Canada by means of loans or advance not bearing a reasonable rate of interest and which remains unpaid for more than one year,” whereas here, no such loan or advance had occurred and that KQI had “instead acquired from Kone BV the shares of Kone USA, which it had agreed to hold for a certain passage of time and to then resell them” (para. 198). Accordingly, the repo transaction “accorded with the object and spirit of TA section 127.6” (para. 202).