Exclusive

BMO didn't inflate losses or dodge tax in $1.7B loan arrangement, judge rules

The Bank of Montreal won't have to pay potentially tens of millions of dollars in disputed taxes after a judge ruled a complicated shell-company structure it used to lend money to its own subsidiaries didn't run afoul of the law.

CRA had alleged bank's foreign shell-company system was 'abusive'

Bank of Montreal has prevailed in a major tax appeal against the government, one of the biggest cases of corporate tax avoidance the CRA has fought in recent years. (Doug Ives/The Canadian Press)

The Bank of Montreal won't have to pay potentially tens of millions of dollars in disputed taxes after a judge ruled a complicated shell-company structure it used to lend money to its own subsidiaries didn't run afoul of the law.

"I find that there was no tax benefit," to how the bank structured its internal loans, Judge David Graham of the Tax Court of Canada wrote in his ruling, released Wednesday.

The decision punctures Canada Revenue Agency (CRA) allegations that the bank's arrangement, used between 2005 and 2010, was an "abusive" scheme to avoid tax that saw BMO inflate its losses by $288 million.

Instead, Graham ruled, that amount was legitimately booked as a foreign-exchange loss because the Canadian dollar had increased substantially against its U.S. counterpart during that time.

"BMO is pleased with the decision," the bank said in a short statement Thursday afternoon.

The CRA said it would "carefully review the decision" before deciding whether to appeal. 

It's the second major ruling within the last week involving the tax machinations of some of Canada's biggest companies. On Friday, a decision by a different judge, mostly in favour of the government, left grocery giant Loblaw Cos. on the hook for $368 million in taxes related to its offshore banking subsidiary in Barbados.

'Tower structure'

In BMO's case, the convoluted transactions — involving shell companies in Nevada, Nova Scotia and Delaware — arose because the bank wanted to lend $1.4 billion US ($1.7 billion Cdn at the time) to its Harris Group subsidiaries in the United States.

"It would not have been tax efficient for BMO to simply borrow the funds and lend them to the Harris Group," Graham wrote in his decision. Doing that would have obliged the bank to pay withholding tax in the U.S. on the interest payments it got from Harris, he noted.

The bank instead 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.

Many types of tower structures were legal at the time in Canada and the U.S., and the CRA has generally allowed them. But in BMO's case, the bank added a twist to hedge against potential U.S.-Canadian currency fluctuations.

When BMO wound up the loan arrangement in 2010, it declared hundreds of millions of dollars in losses based on the 20 per cent increase in the value of the loonie versus the U.S. dollar during that time.

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

On Wednesday, however, Graham sided with the bank, ruling that BMO's loan structure did not meet all the elements of the test to invoke the GAAR. He allowed $288 million in losses claimed by BMO and sent the matter back to the CRA to reassess the bank's tax obligations for the 2010 tax year.

BMO also won an as-yet undetermined amount of costs against the government.


Background on the case:

The Bank of Montreal's fight with the taxman centred 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.

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 didn't object to some of that loss, but deemed $288 million to be inflated. It claimed that a Section 112 (3.1) of the Income Tax Act required the bank to offset its loss by the dividends the Nevada partnership received on its shares in the Nova Scotia company. 
  • The bank disagreed and prevailed in Tax Court, with a judge rejecting the CRA's interpretation. 

Read more about Canadian companies' tax arrangements:

With files from CBC's Harvey Cashore