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Witch hunts may be history, but there's one of a similar nature being conducted by the Canada Revenue Agency. Its actions are, to put it politely, a shameful display of abusive authority. The good news? A recent court decision put the taxman in his place. Let's hope the case helps others in the same predicament. Let me explain.

The problem

For a number of years, the taxman has been trying to prevent Canadians from hiding money offshore to evade tax. I have no problem with this. If you're illegally evading tax you won't find many sympathetic to your cause. The problem is that the taxman has begun a hunt to uncover offshore tax cheaters that is catching far too many innocent investors in the net.

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Those in the tax community saw this coming a couple of years ago when the government started collecting more information than ever from taxpayers making investments outside of Canada (using a revised Form T1135).

I'm talking about Canadians – and not the wealthy alone – making investments in securities outside of Canada, including mutual or pooled funds, simply looking for investment returns at lower risk levels than what they have been able to find otherwise.

The law

Our tax law contains "Offshore Investment Fund Property" (OIFP) rules in Section 94.1. The objective of these rules is to ensure that "capital export neutrality" is achieved. In theory, this means that the decision of a taxpayer to make investments outside of Canada should be a neutral decision which is not tax-driven.

Section 94.1 will arbitrarily add an amount to your taxable income if you meet two tests. The first is the "value test" where you've invested in a fund or pool outside of Canada that derives its value primarily from portfolio investments. This test will be met in a lot of cases. The second is the "motive test" where it may reasonably be concluded that one of the main reasons you invested in the fund was to pay less tax than you would have otherwise if you had held the underlying investments of the fund directly.

Unfortunately, the onus is on you – the taxpayer – to demonstrate that saving tax was not one of your main reasons for making the investment. You might find some help in the story of Gerbro Holdings Co.

The story

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On July 22, the Tax Court of Canada handed down its decision it the case Gerbro Holdings Co. (Gerbro) v. The Queen. This is a story about an investor with capital in a holding company that was invested in various hedge funds located outside of Canada. These funds were located in low-tax jurisdictions and made no distributions, so the taxman was offended and applied Section 94.1 to the 2005 and 2006 tax years of Gerbro, adding amounts to taxable income in those years.

There were some key objectives that the investor was trying to achieve here, namely: Preservation of capital, generation of cash flow to cover living and other expenses, returns in line with market expectations, keeping volatility low and maintaining liquidity. A tall order, perhaps. But the investor relied on professionals to identify money managers that had a track record of accomplishing these things. The idea was to find these managers wherever in the world they might be. Some were Canadian, some were not.

In the end, the court sided with the investor. Past cases established some principles: First, that it's improper to conclude that resulting tax savings automatically lead to the inference that obtaining those tax savings must have been a main reason for investing. Next, choosing to invest in a non-resident entity when there was the possibility of investing in another vehicle triggering a larger tax liability is not necessarily determinative of tax benefits as main reason to invest.

The judge concluded that tax reduction might have been an ancillary reason to invest, but not a main reason in the Gerbro case. The investor simply wanted to invest with trustworthy individuals who could achieve the stated objectives. The Canada Revenue Agency failed to understand the choice of investments within the context of these objectives – not surprisingly. What does all of this mean for you? This case, and CRA's hunt for tax cheats, should inform how you structure a portfolio that might include funds outside of Canada. I'll talk about that next time.

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