The Bank of Montreal ran an "abusive" tax avoidance scheme for five years using foreign shell companies that deliberately thwarted Canada's tax laws, the federal government alleges.

Tax Court of Canada documents, obtained by CBC News and the Toronto Star, describe how BMO's U.S. operations routed $1.4 billion US ($1.7 billion Cdn at the time) through companies in Nevada, Nova Scotia and Delaware. The Canada Revenue Agency says the bank inflated its losses by $288 million Cdn in fiscal 2010 to dodge millions in tax.

"The avoidance transactions were abusive," a Department of Justice lawyer writes in an April 2016 filing on behalf of the CRA. The BMO scheme "circumvented" parts of the Income Tax Act "in a manner that frustrated or defeated its object, spirit and purpose."

The money used in the arrangement came from bonds the bank sold in Europe and the United States. BMO doesn't dispute the transactions, but in its court filing appealing the CRA's assessment insists they were for "bona fide purposes," that it did not abuse the law and that the losses were legitimate and the result of currency fluctuations.

In a statement, the bank said: "This case relates to the impact of changes in foreign exchange rates on the funding of our U.S. operations by one of our Canadian companies. We intend to defend our position."

News of the Tax Court battle coincides with unrelated BMO dealings in the tax-haven of Bermuda being laid bare in the Paradise Papers. While investigating references to BMO in the trove of leaked documents, CBC News looked into Canadian court files about the bank and discovered records about this case.

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Double-dipping

BMO's dispute with the CRA comes as dozens of countries, including Canada, are banding together to enact measures to limit the scope of the various cross-border tactics big companies can use to minimize their tax bills. Such schemes, openly employed by companies from Apple to Starbucks, see businesses legally route profits through low-tax jurisdictions or exploit loopholes in countries' laws.

In the BMO case, the bank used what's known in accounting circles as a "tower structure," which involves setting up special types of companies in the U.S. and Canada that are treated differently in each country under their respective tax codes.

Paradise Papers: The scope

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By transferring funds through those subsidiaries, a parent company can take advantage of so-called double-dip financing — borrowing money and then claiming the cost of the interest as a business expense twice, once in Canada and once in the U.S.

"It's obvious that it was put together by smart accountants and lawyers — I assume to maximize, under the letter of the law, tax efficiency," said Martin Kenney, a Canadian offshore lawyer based in the British Virgin Islands.

Many types of tower structures and double-dipping are legal in Canada and the U.S., and the CRA has generally allowed them. But in the case of BMO's scheme, which operated from 2005 to 2010, the bank added a twist and ended up declaring hundreds of millions of dollars in losses based on the 20 per cent increase in the Canadian dollar against its U.S. counterpart during that time.

CRA won't comment

Not so fast, the CRA said. It invoked a section of the Income Tax Act called the general anti-avoidance rule that invalidates tax-minimizing schemes that comply with the letter of the law but thwart its spirit or purpose.

The dispute is scheduled for trial next June in Toronto.

The CRA said it wouldn't comment on the matter while it's before the court.


BMO Money Trail

The Bank of Montreal's fight with the taxman centres on a convoluted series of loans and share purchases that began more than a decade ago and used shell companies in Nevada, Delaware and Nova Scotia, Tax Court filings show.

"You would use Nevada and Delaware … because they're efficient, they're cheap to set up, lawyers are used to using them," said Martin Kenney, a Canadian offshore lawyer based in the British Virgin Islands.

Here's what happened:

  • In April 2005, the bank set up a Nevada limited partnership, which itself incorporated a Nova Scotia company as a subsidiary. The Nova Scotia company then founded its own subsidiary in Delaware.
  • Shortly after, BMO's Chicago branch borrowed $150 million US ($187 million Cdn at the time) from outside lenders. It used the money to fund the Nevada partnership. The Nevada partnership took the money and invested it in the Nova Scotia company, which, in turn, used the funds to buy common shares in its Delaware subsidiary.
  • Separately, the Nevada partnership borrowed $1.25 billion US ($1.6 billion Cdn) from banks in Europe and used that money to buy yet further shares in the Nova Scotia company. The Nova Scotia corporation used that money, too, to buy additional common shares in its Delaware entity.
  • The Nova Scotia corporation quickly swapped its common stock in the Delaware company for preferred shares that paid dividends. The Nevada company got preferred shares in the Nova Scotia corporation.
  • The Delaware company then took the nearly $1.4 billion US it had received from the Nova Scotia corporation and lent it back to BMO's U.S. operations based in Chicago, earning interest on those loans.
  • The Delaware company used the income from that interest to pay dividends on its preferred shares to the Nova Scotia company, which in turn paid dividends on its own preferred shares to the Nevada partnership.
  • When BMO unwound the tower structure in 2010, the Canadian dollar had gone up more than 20 per cent since 2005 against the U.S. dollar. That led the bank to claim a $322-million Cdn capital loss on the Nevada partnership's common shares in the Nova Scotia company. The CRA doesn't object to some of that loss, according to the court documents, but deems $288 million to be inflated.
  • Normally, such a loss would be offset by any dividends the Nevada partnership received on its common shares in the Nova Scotia company. But because the dividends came via preferred shares and not common shares, the bank didn't factor them in to reduce its claimed loss.
  • The CRA alleges that BMO had no bona fide reason to pay dividends through the preferred shares as opposed to the common shares, and that the "primary purpose and result" of that decision "was the circumvention" of the relevant section of the Income Tax Act in a way that was an "abuse, having regard to the act read as a whole."