T-4298-78
Consolidated-Bathurst Limited (Plaintiff)
v.
The Queen (Defendant)
INDEXED AS: CONSOLIDATED-BATHURST LTD. V. CANADA
Trial Division, Strayer J.—Toronto, January 22;
Ottawa, February 15, 1985.
Income tax — Income calculation — Deductions — Plain
tiff setting up offshore insurance subsidiary — Risk reinsured
with offshore company — Percentage of premiums transferred
to subsidiary — "Premiums" paid by plaintiff directly or
indirectly to subsidiary disallowed as insurance expenses
Whether premiums deductible under ss. 18(1)(e) and 245(1) —
No sham — Existence of bona fide business purposes not
immunizing taxpayer from tax liability — Premiums artifi
cially reducing plaintiffs income therefore not deductible
under s. 245(1) — Corporate veil pierced — Subsidiary bound
"hand and foot to parent company" — Reserve fund created in
hands of subsidiary to pay for potential losses not covered by
third parties — No deduction allowed under s. 18(1)(e) —
Relevancy of American case law — No risk-shifting or dis
tributing — Attribution to plaintiff of interest income earned
by subsidiary wrong — Laws of property applying — Income
of subsidiary not income of parent in absence of specific rule
— Appeal from reassessments allowed in part — Income Tax
Act, S.C. 1970-71-72, c. 63, ss. 18(1)(e), 245(1).
The difficulty and cost of obtaining insurance in Canada led
the plaintiff, a pulp and paper manufacturing company, to set
up an insurance subsidiary, OI, which carried on business in
Bermuda. As a result of this new program, the plaintiff took
out "deductibles policies". The insurance companies would
reinsure with OI a percentage of the risk under the deductibles
policies sold by them to the plaintiff. They would also transfer
to OI a percentage of the premiums received from the plaintiff.
The premiums paid by OI for reinsurance were only a small
portion of the amounts received by it in premiums from those
companies. OI retained the remaining risk which it did not
reinsure.
The Minister disallowed the "insurance expenses" claimed as
deductions by the plaintiff for its taxation years 1971 to 1975
while attributing to it the "interest income" earned by OI.
The Minister contends that by this self-insurance scheme, the
plaintiff created a reserve fund in the hands of OI to pay for
potential losses to its property not covered by insurance with
third parties, and that the money so directed to OI could not be
deducted as expenses. The questions are whether the plaintiff's
transactions involved a sham, and whether the "premiums"
paid to OI were non deductible by virtue of paragraph 18(1)(e)
which prohibits the deduction of an amount transferred to a
reserve, and of subsection 245(1) which provides that no dis
bursement can be deducted if it artificially reduces income.
Held, the reassessment with respect to the attribution to the
plaintiff of "interest income" earned by OI should be referred
back to the Minister but the action should otherwise be
dismissed.
The plaintiffs insurance program was undertaken to serve
bona fide business purposes. The difficulties in obtaining insur
ance at a reasonable cost provided an important motivation for
entering into the program with OI. The plaintiffs transactions
did not constitute a "sham". The legal relationships as between
the various companies and with outside insurers were all appar
ently legally binding contracts giving rise to enforceable obliga
tions. The existence of a bona fide business purpose could not,
however, immunize the taxpayer from tax liability if the trans
action otherwise attracts tax.
The question whether the "premiums" paid to OI directly or
indirectly artificially reduced the plaintiffs income and were
therefore not deductible was to be answered in the affirmative.
The term "artificially" was defined in Don Fell Limited v. The
Queen (1981), 81 DTC 5282 (F.C.T.D.) as meaning "not in
accordance with normality". It was, on occasion, permissible to
pierce the corporate veil so as to "examine the realities of the
situation" and determine whether the "subsidiary company was
bound hand and foot to the parent company" as stated in
Covert et al. v. Minister of Finance of Nova Scotia, [1980] 2
S.C.R. 774.
Since OI was a wholly owned subsidiary of St. Maurice
Holdings Ltd., which was, in turn, a wholly owned subsidiary of
the plaintiff, it could only be inferred that OI "had to do
whatever its parent said" as put in the Covert case. The
insurance program was a device for channelling funds from the
plaintiff to one of its own instrumentalities over which it had
complete control. Furthermore, the evidence indicated that the
reinsurance obtained was available to any insurance company
whether a captive or not. The "premiums" paid by the plaintiff
were in effect amounts transferred to a reserve fund and
therefore not deductible by virtue of paragraph 18(1)(e).
A number of American cases had dealt with the notion of
risk-shifting and risk-distributing in insurance matters. The
essence of insurance was the transfer of a risk to an individual
or a corporation in the business of assuming the risk of others.
In the present case, the risk has not been shifted to anyone
other than an instrumentality of the insured, an instrumentality
which draws all of its assets directly or indirectly from the
insured. This does not correspond to a true shifting of the risk.
The payment of "premiums" to OI artificially reduced the
income of the plaintiff.
The Minister, while disallowing the deduction for premiums
paid indirectly or directly to OI, allowed to be subtracted from
the amounts disallowed the amounts actually paid out by OI
with respect to losses to the plaintiff's property. The net effect
was to reduce the plaintiffs income by that amount. That
reassessment was correct. On the other hand, the Minister's
decision to attribute to the plaintiff amounts earned by OI in
interest or exchange with respect to the funds in the possession
of the latter was incorrect. The normal laws of property should
apply. The income of a subsidiary cannot be regarded as the
income of the parent in the absence of a specific rule so
providing. Subsection 245(1) does not apply to the interest or
exchange income of 01 and in the absence of a sham, the
normal distinctions between a parent and its subsidiary should
be observed.
CASES JUDICIALLY CONSIDERED
FOLLOWED:
Covert et al. v. Minister of Finance of Nova Scotia,
[1980] 2 S.C.R. 774.
APPLIED:
Don Fell Limited v. The Queen (1981), 81 DTC 5282
(F.C.T.D.); Sigma Explorations Ltd. v. The Queen,
[ 1975] F.C. 624 (T.D.); Helvering v. Le Gierse, 312 U.S.
531 (1941); Carnation Co. v. C.I.R., 640 F.2d 1010 (9th
Cir. 1981); certiorari denied 454 U.S. 965 (1981);
Stearns-Roger Corp., Inc. v. U.S., 557 F.Supp. 833
(U.S.D.Ct. 1984).
CONSIDERED:
Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R.
536; 84 DTC 6305; Snook v. London & West Riding
Investments, Ltd., [1967] 1 All E.R. 518 (C.A.).
REFERRED TO:
R. v. Parsons, [1984] 2 F.C. 909; [1984] CTC 354
(CA.); Shulman, Isaac v. Minister of National Revenue,
[1961] Ex.C.R. 410; Fraser Companies Ltd. v. The
Queen, [1981] CTC 61 (F.C.T.D.); The Queen v. Red-
path Industries Ltd. et al. (1984), 84 DTC 6349 (Que.
S.C.).
COUNSEL:
Donald G. H. Bowman, Q.C. and M. A. Mon-
teith for plaintiff.
Wilfrid Lefebvre, Q.C., J. Côté and J. D'Au-
ray for defendant.
SOLICITORS:
Stikeman, Elliott, Toronto, for plaintiff.
Deputy Attorney General of Canada for
defendant.
The following are the reasons for judgment
rendered in English by
STRAYER J.:
Facts
The plaintiff commenced this action to appeal
reassessments by the Minister of National Reve
nue with respect to the taxation years 1972 to
1975 inclusive and to appeal against the disallow-
ance of certain expenditures during 1970 and 1971
which, while there was no tax owing in those years,
would affect the amount of losses which it could
carry forward into subsequent years.
During the course of the trial the Court was
informed that certain issues had been resolved and
counsel for both parties signed a "Partial Consent
to Judgment" with respect to these matters which
will be incorporated in the final judgment.
Essentially what remains in issue is the disallow-
ance of certain "insurance expenses" as deductions
from the income of the plaintiff in the taxation
years 1971-1975 inclusive, together with the attri
bution to the plaintiff of certain "interest income"
earned during that period by two companies relat
ed to the plaintiff, namely Overseas Insurance
Corporation and Overseas Insurance Limited. The
latter companies earned this interest on funds
received directly or indirectly from the plaintiff.
All together, some $5 million of putative income is
at issue before me.
The plaintiff company was formed in 1967 as a
result of an amalgamation of Consolidated Paper
Corporation Limited and Bathurst Paper Limited.
It carries on business in Canada and throughout
many other countries as a manufacturer of pulp
and paper and packaging. It has some twenty to
thirty subsidiaries throughout the world. One of
these is St. Maurice Holdings Limited, a wholly
owned subsidiary of the plaintiff formed for the
purpose of holding shares in affiliate and subsidi
ary corporations outside of Canada.
According to the agreed statement of facts and
the evidence, in the late sixties insurance for those
in the pulp and paper industry was becoming
difficult and expensive to obtain in Canada. The
plaintiff had particular problems because of high
loss records. But it was obliged to have insurance
under trust deeds presumably relating to outstand
ing loans. In 1970, the plaintiff's Board of Direc
tors after receiving advice on the matter decided to
form an insurance subsidiary of its own. Without
going into the details, it is apparent from the
evidence that several factors influenced the Board
of Directors in reaching this decision. The difficul
ty in, and cost of, obtaining insurance was a factor
which the defendant does not dispute, although it
does question the degree to which the solution
adopted was necessary and effective in solving that
problem. It is apparent that the idea of establish
ing such a subsidiary offshore was attractive, both
from the standpoint of avoiding effective regula
tion of the insurance industry such as exists in
Canada and avoiding Canadian taxes. As a result,
the plaintiff incorporated in Panama a company,
Overseas Insurance Corporation, in 1970, and that
corporation became licensed to carry on insurance
business in Bermuda. That corporation was wholly
owned by St. Maurice Limited, which as noted
before, is in turn wholly owned by the plaintiff. In
1974 Overseas Insurance Corporation was
replaced by Overseas Insurance Limited, which
was incorporated that year in Bermuda. That com
pany also was wholly owned by St. Maurice Lim
ited and all the assets of Overseas Insurance Cor
poration were transferred to it. I think nothing
turns on the transformation of the Panamanian
company into a Bermudan company and I shall
refer to these two companies collectively as "OI".
The total capitalization of OI at its inception in
1970 was $120,000 consisting of 12 common
shares at $10,000 per share, subscribed by St.
Maurice.
It appears that OI has never had any employees
of its own but is managed under a contract by
Insurance Managers Limited, a Bermuda corpora
tion which is a wholly owned subsidiary of Reed,
Shaw Osler Limited, Canadian insurance brokers
who were largely instrumental in advising the
plaintiff to establish an offshore "captive" insurer.
Testimony before me by the President of Insur
ance Managers Limited, Mr. David A. Brown,
indicates that with a staff of thirty-five in Hamil-
ton, Bermuda, Insurance Managers Limited man
ages some fifty-five captive insurance companies
which have all decided to have their head offices in
Bermuda.
Given the vastness of its holdings and opera
tions, the plaintiff had at any one time a large
array of insurance policies. During the period in
question, it had general policies which applied to
different kinds of risks and different kinds of
property and which had high deductible levels.
Some of these deductibles were as high as
$500,000 annual aggregate. As a result of its new
insurance program adopted in 1970, the plaintiff,
in addition to these policies, entered into an insur
ance contract with Victoria Insurance Company of
Canada whereby these deductible amounts were
covered by one "deductibles policy" which would
insure the plaintiff against losses in amounts less
than the deductibles in its general insurance poli
cies. (I understand that the deductibles policies
normally had a small deductible as well, although
it is not apparent to me that this was true in the
case of the policy with the Victoria Insurance.)
This "deductibles" coverage was thus for the "pri-
mary" layer of risk, as contrasted to the "catas-
trophe" layer covered by the general policies with
high deductibles. The policy with Victoria Insur
ance was for the last five months of 1970. Concur
rently with Victoria entering into this policy, Vic-
toria entered into an "open facultative agreement"
with OI whereby Victoria reinsured with OI 92.5%
of the liability under the deductibles policy sold by
it to the plaintiff. It also transferred to OI 92.5%
of the premium it had received from the plaintiff
less commissions. It is not clear to me whether OI
reinsured any or all of this risk, and since the
plaintiff's expenditures for the 1970 taxation year
are no longer in question in this action I need not
consider this point further.
During the years 1971 to 1974 inclusive the
plaintiff obtained instead a similar deductibles
policy, number 95022, from Scottish and York
Insurance Co. Limited, another Canadian insur
ance company which was associated with Victoria
Insurance. Similarly Scottish and York concur
rently entered into an open facultative agreement
with OI and reinsured 92.5% of the risk with OI,
paying OI a premium equivalent to 92.5% of the
premium received by Scottish and York from the
plaintiff, less commissions. In each of these years
OI reinsured a substantial part of the risk which
had been ceded to it by Scottish and York. This
reinsurance was apparently in the form of "exces-
sive loss" or "stop loss" insurance. It appears that
the premiums paid by OI for reinsurance were
only a small portion of the amounts received by it
in premiums from Scottish and York. OI retained
the remaining risk which it did not reinsure.
During the years of contract number 95022 with
Scottish and York, the "deductibles policy", Scot-
tish and York required an agreement of indemnifi
cation with St. Maurice, the sole shareholder of
OI, to the effect that St. Maurice would indemnify
Scottish and York for any loss to Scottish and
York resulting from the failure of OI to fulfil its
obligations under the open facultative agreement.
This indemnification agreement was first entered
into in January 1972. OI was also required to
provide to Scottish and York a letter of credit
drawn on the Bank of Montreal, and secured with
time deposits of OI at the Bank of Bermuda. The
plaintiff itself was also required to provide to the
Bank of Montreal a guarantee of this letter of
credit.
The letter of credit in favour of Scottish and
York was originally in the amount of $500,000 but
had been raised to $1,000,000 by the end of 1974.
The agreement of indemnification provided by St.
Maurice, the plaintiffs wholly owned subsidiary,
was for all liability, loss and expense that Scottish
and York might incur by reason of the failure of
OI "to perform any or all of its obligations to
[Scottish and York] with respect to transactions
between [Scottish and York] and St. Maurice
Holdings Limited and/or Consolidated-Bathurst
Limited". The evidence was to the effect that
Scottish and York required the agreement of
indemnification because that company did not
know much about OI or who it would be reinsur-
ing with. The letter of credit was needed to enable
Scottish and York to provide security deposits with
the Superintendent of Insurance which were
required because it had reinsured with an insurer
(OI) unlicensed in Canada.
In 1975, the deductibles policy number 95022
with Scottish and York was replaced by a deduct
ibles policy number 109851 with Elite Insurance
Company, another Canadian insurer. Elite similar
ly entered into an open facultative agreement with
OI and reinsured with OI 97% of its liability under
policy 109851. A letter of credit in the amount of
$1,000,000 in favour of Elite was provided by OI,
drawn on the Bank of Nova Scotia using time
deposits of OI at the Bermuda National Bank as
security. This letter of credit was subsequently
raised to $1,500,000. Elite did not require an
indemnification agreement with St. Maurice nor
was it necessary for the palintiff to guarantee the
letter of credit. In this case also Elite paid to OI
97% of the premiums it had received from the
plaintiff, minus commissions, and OI reinsured a
substantial part of the risk with other reinsurance
companies. Again, the amounts OI paid out in
reinsurance premiums were only a small portion of
the amounts received by it from Elite in premiums,
and again OI retained that portion of the risk
ceded by Elite that it did not reinsure.
During the period 1971-75 the plaintiff also had
a series of "composite" policies covering risks or
layers of risk different from the coverage in the
deductibles policies. From March 1971 to March
1973 the composite policy was placed with a
number of insurers, each company taking a certain
percentage of the risk under the policy. In this case
OI acted as one of the insurers, contracting direct
ly with the plaintiff. In the first year of this policy
OI contracted for 25% of the risk, and in the
second year 40% of the risk. It received premiums
directly from the plaintiff and reinsured most of
the risk with Lloyds of London. In the third and
fourth years of this period, the plaintiff obtained a
composite policy from Lloyds for 100% of the risk.
Lloyds in turn reinsured a portion of the risk with
OI. Again, in all these cases, the premiums paid
out by OI were only a small portion of the premi
ums received by it directly from the plaintiff or
from Lloyds.
OI did pay out on certain losses during this
period ranging from only $26,812 in 1973 to as
much as $493,306 in 1972. Nevertheless OI seems
to have prospered, its current assets growing from
$1,262,109 at the end of 1971 to $3,743,125 at the
end of 1975. Its cash on hand grew from $315,109
at the end of 1971 to $3,716,434 at the end of
1975.
In filing its income tax returns for the years in
question, the plaintiff claimed as expenses the
premiums paid with respect to insurance on its
own property, including amounts paid directly or
indirectly to OI with respect to insurance or rein-
surance provided by OI on the plaintiff's property.
The Minister in his reassessments has taken the
position that any amounts retained by OI, not
expended by it in reinsurance premiums or for
payment of the plaintiff's losses, are not properly
deductible from the plaintiff's income. This applies
both to money received from premiums paid to it
for insurance or reinsurance on the plaintiff's
property and interest earned on monies held by OI.
The Minister contends that the services provided
by the "captive insurer", OI, were not insurance
services with respect to that portion of the risk
which OI retained and did not reinsure. The Min
ister contends instead that this was an elaborate
scheme of self-insurance whereby the plaintiff
established a fund to bear its own risks to the
extent that those risks were not allocated to non-
related insurers and reinsurers. The only property
with respect to which OI undertook a risk was that
of the plaintiff, and all of its revenues came direct
ly or indirectly from the plaintiff. The Minister
therefore contends that amounts paid by the plain
tiff with respect to that portion of the risk to its
property borne by OI cannot be deducted from the
taxpayer's income. He relies on paragraph
18(1)(e) of the Income Tax Act [S.C. 1970-71-72,
c. 63] which provides as follows:
18. (1) In computing the income of a taxpayer from a
business or property no deduction shall be made in respect of
(e) an amount transferred or credited to a reserve, contingent
account or sinking fund except as expressly permitted by this
Part;
Counsel for the Minister contended that what the
plaintiff had done was to create a reserve fund in
the hands of OI for paying for such potential losses
to the plaintiff's property as were not covered by
insurance with third parties. Therefore, it is con
tended, the money so directed to OI cannot be
deducted as expenses. Further, subsection 245(1)
is invoked. It provides:
245. (1) In computing income for the purposes of this Act, no
deduction may be made in respect of a disbursement or expense
made or incurred in respect of a transaction or operation that,
if allowed, would unduly or artificially reduce the income.
For its part, the plaintiff contends that all of
these transactions were genuine, legal, and
enforceable; that they were all normal insurance
contracts; that it matters not whether the compa
nies involved are interrelated as, in law, they are
separate entities; that it cannot be assumed that
OI acted as an agent of the plaintiff because it was
a separate corporation; that there is no "sham"
involved here; and that this insurance program was
entered into by the plaintiff primarily for business
purposes without taxation being a significant
consideration.
Conclusions
I believe that some issues can be readily dis
posed of.
A great deal of time was spent at the trial in
demonstrating that this "insurance program" was
or was not undertaken for bona fide business
purposes. It appears to me that the program was
undertaken, and assumed this form, to serve sever
al purposes, among them being bona fide business
purposes. I think it was demonstrated, and I do not
believe the defendant really contests the fact, that
in the late 1960's the plaintiff was experiencing
problems in obtaining insurance, or obtaining it at
a reasonable cost. To what extent this problem was
solved by the program was not clear from the
evidence, but at least it did provide an important
motivation for entering into the program with a
"captive insurer". Having decided that, there were
reasons other than tax reasons for the resort to
other jurisdictions: apparently incorporation was
available more quickly in Panama, and licensing
for the operation of an insurance business was a
good deal less onerous in Bermuda than it was in
Canada. The safeguards thought necessary in
Canada for the protection of the public were
apparently not thought necessary in Bermuda. The
evidence certainly also indicates that there was
information put before the plaintiffs Board of
Directors by its advisors and officers indicating the
tax advantages of having a captive insurer estab
lished in a tax haven such as Bermuda. It is
impossible to say to what extent these various
factors were instrumental in bringing about the
decision to establish that program nor need I do so.
I am now bound by the decision of the Supreme
Court of Canada in Stubart Investments Ltd. v.
The Queen, [1984] 1 S.C.R. 536; 84 DTC 6305,
since followed by the Federal Court of Appeal in
R. v. Parsons, [1984] 2 F.C. 909; [1984] CTC
354. In the Stubart case the Supreme Court held
that a transaction may not be disregarded for tax
purposes solely on the basis that it was entered into
by a taxpayer without an independent or bona fide
business purpose. While the Court recognized that
the lack of such purpose might bring a taxpayer
within what is now subsection 245(1), that provi
sion was not relied on in the Stubart case. This
means, apparently, that not only is a taxpayer not
precluded from arranging his affairs to minimize
his tax, but the courts should normally treat as
valid arrangements made by him which have no
purpose except the avoidance of tax, i.e. no bona
fide business purpose. But I take a corollary of this
to be that the presence of a bona fide business
purpose does not immunize the taxpayer from tax
liability, if the transaction otherwise attracts tax.
So I think this issue need not be considered
further.
It also appears to be a part of the Minister's
assumptions that these arrangements were a sham
and that therefore OI must be regarded as the
agent of the plaintiff with respect to collecting and
holding a reserve fund and earning interest there-
on. The standard definition of a "sham", con
firmed again by the Supreme Court of Canada in
the Stubart case (supra) at pages 572 S.C.R.;
6320 DTC is that stated by Lord Diplock in Snook
v. London & West Riding Investments, Ltd.,
[1967] 1 All E.R. 518 (C.A.), at page 528, where
he said that a sham consists of acts
... which are intended by them to give to third parties or to the
court the appearance of creating between the parties legal
rights and obligations different from the actual legal rights and
obligations (if any) which the parties intend to create.
I do not think that the arrangements entered into
by the plaintiff and its subsidiaries can be regard
ed as a sham. The legal relationships as between
the various companies and with outside insurers
were all apparently legally binding contracts
giving rise to enforceable obligations. There was
no back-dating, etc., as is typical of a sham.
This leaves the question, however, as to whether
the arrangement should be seen as "artificially"
reducing the plaintiff's income because any pay
ments by it to OI in respect of risks assumed by OI
on the plaintiff's property are amounts transferred
to a reserve and thus expenses which are not
deductible from the plaintiff's income by virtue of
subsection 245 (1) and paragraph 18(1)(e).
As I understand the Stubart case, it does not
address the issue of what would be an artificial
reduction of income as contemplated in subsection
245(1) or its predecessor. Estey J. at pages 569
S.C.R.; 6319 DTC noted that the Crown had not
invoked section 137, the predecessor to subsection
245(1). He noted at pages 577-580 S.C.R.; 6323-
6324 DTC that the lack of a bona fide business
purpose might, depending on all the circum
stances, make section 137 applicable. I do not
understand this to mean, however, that the pres
ence of a bona fide business purpose necessarily
makes section 137 or its successor inapplicable.
That is, the absence of a bona fide business pur
pose is not a condition precedent to the application
of subsection 245(1) if artificiality is otherwise
established, and the Supreme Court has not
defined artificiality as it was not in issue in the
Stubart case. In the present case, unlike the Stu-
bart case, the Minister is specifically relying on
subsection 245 (1) on the basis that the payments
in issue would artificially reduce the plaintiff's
income.
Other cases have assisted in defining artificial
ity. In Don Fell Limited v. The Queen (1981), 81
DTC 5282 (F.C.T.D.), Cattanach J. said at page
5291 that subsection 245(1) is directed "not only
to sham transactions but to something less as
well". At page 5292 he adopted a definition of
"artificially" as meaning "not in accordance with
normality". He quoted with approval Collier J. in
Sigma Explorations Ltd. v. The Queen, [1975]
F.C. 624 (T.D.), at page 632, where the latter said
that a judge must determine objectively whether
section 137 (now section 245) applies, having
regard not only to the taxpayer's evidence but also
to all the surrounding facts. A similar definition of
"artificially" was adopted by the Exchequer Court
in Shulman, Isaac v. Minister of National Reve
nue, [1961] Ex.C.R. 410, at page 425.
It therefore seems to me that I must look at
these "insurance" arrangements of the plaintiff to
see whether they accord with normal concepts of
insurance or whether the monies paid to OI direct
ly or indirectly by the plaintiff, purportedly as
premiums, should be non-deductible as artificially
reducing its income.
Counsel for the plaintiff stressed that, in law,
companies are separate entities from their share
holders and that they are not automatically the
agents of their shareholders. He stressed that all of
the transactions in question were in proper legal
form and established legally enforceable rights and
obligations. I accept those propositions but I do
not think that they are determinative of the
matter. In tax cases it is permissible to pierce the
corporate veil on occasion. As the majority in the
Supreme Court of Canada held in Covert et al. v.
Minister of Finance of Nova Scotia, [1980] 2
S.C.R. 774, at page 796:
This is eminently a case in which the Court should examine
the realities of the situation and conclude that the subsidiary
company was bound hand and foot to the parent company and
had to do whatever its parent said. It was a mere conduit pipe
linking the parent company to the estate.
It was not contested in the present case that there
were no officers or employees of the plaintiff on
the Board of OI. But the latter company was a
wholly owned subsidiary of St. Maurice, which
was in turn a wholly owned subsidiary of the
plaintiff, and it is hardly credible that the plaintiff
would have tolerated important decisions being
taken by the Board of OI which were other than in
accord with the plaintiff's insurance program. One
can only infer that OI "had to do whatever its
parent said", as the Supreme Court put it in the
Covert case, and that that parent (St. Maurice)
had to do what its parent (Consolidated-Bathurst)
said. There was certainly nothing in the evidence
to suggest that OI had ever diverged from the
implementation of the plaintiff's plan for risk
management.
To the extent that such risks connected with the
plaintiff's property were not insured or reinsured
with unrelated companies, those risks remained
with OI. All of OI's assets had their ultimate
source in the plaintiff. Its original capitalization of
$120,000 came from St. Maurice, the plaintiff's
wholly owned subsidiary; its revenues came direct
ly from the plaintiff as insurance premiums, or
indirectly from the plaintiff as reinsurance premi
ums from the plaintiff's insurers; together with
such rebates or commissions as it might earn on
insuring or reinsuring the plaintiff's property, and
interest earned on surplus funds having their ulti
mate source in the plaintiff. OI had no other
customers among whom to spread the risk, nor any
other source of funds from which the plaintiff
could be paid for losses within the area of risk
retained by OI. Therefore the "insurance pro
gram" must be seen as a device for channelling
funds from the plaintiff to one of its own
instrumentalities over which it had complete con
trol, and to which it would have to look to pay
losses on risks retained by OI. Any funds available
in OI would be funds having their origin with the
plaintiff. Any surplus OI might enjoy would ulti
mately be under the control of the plaintiff as the
sole shareholder of the sole shareholder of OI. Any
losses which OI did not have assets to cover would
have to be borne by the plaintiff. The net result is
similar to the establishment of a reserve fund by
any institution or corporation from which it would
plan to pay for uninsured losses to its property.
Nor was it established by the evidence that this
was only an incidental consequence of an arrange
ment required by the plaintiff for obtaining insur
ance from third parties. For example, the evidence
indicates that the premiums paid to Scottish and
York, the Canadian insurer, were the same as it
would have charged to any insured whether or not
the insured had a captive insurance company to
act as reinsurer. By the same token this suggests
that there was no market advantage in having a
captive reinsurer. Similarly, although it was said
that one of the reasons for establishing a captive
insurer was to obtain access to reinsurance mar
kets not available otherwise than to a captive
insurance company, in fact the evidence indicates
that the reinsurance obtained was available to any
insurance company whether a captive or not.
Therefore the use of the captive insurance com
pany in part to cover risks not otherwise reinsured
was not merely incidental to an arrangement for
obtaining from third parties reinsurance not other
wise available.
Therefore I conclude that the so-called "premi-
ums" paid by the plaintiff in respect of risks for
which its instrumentality, OI, assumed the respon
sibility, were disbursements which would artificial
ly reduce the income of the plaintiff and are
therefore not deductible from its income, pursuant
to subsection 245(1). In fact such disbursements
were in effect amounts transferred to a reserve
fund and are therefore not deductible by virtue of
paragraph 18(1)(e) of the Income Tax Act.
In coming to this conclusion I am also
influenced by some decisions of the United States
courts which, although not dealing with the same
statutory framework, are useful in representing a
realistic analysis of relationships allegedly involv-
ing insurance. In Helvering v. Le Gierse, 312 U.S.
531 (1941) the Supreme Court of the United
States had before it an insurance contract and an
annuity contract entered into by the deceased
dated one month prior to her death at the age of
80. The amounts paid by her under these contracts
in premiums exceeded the amount payable under
the insurance policy which was for the benefit of
her daughter. The Court held that in calculating
the value of the deceased's estate the amount
payable under the insurance contract had to be
included because it was not truly insurance. At
page 539 the Court said "historically and com
monly insurance involves risk-shifting and risk-dis
tributing". In that case there was simply no risk:
during her lifetime the premium paid by the
deceased would provide more than enough interest
to pay the annuity as long as it was required; and
upon her death the amounts paid by her for the
life insurance premium and the annuity contract
would more than cover the amount payable under
the life insurance policy. In the present case, with
respect to losses not insured with third parties, the
plaintiff was obliged to look to its own instrumen
tality, OI, for any funds it might require to replace
the losses on such property. If the money were not
there—money which incidentally had come from
the plaintiff directly or indirectly—then the plain
tiff would not be recompensed for its loss, at least
unless it provided the funds to this subsidiary of its
subsidiary with which to reimburse itself. There
fore, the risk had not been shifted or distributed.
More directly relevant is the case of Carnation
Co. v. C.I.R., 640 F.2d 1010 (1981), a decision of
the U.S. Court of Appeals, 9th Circuit, in which
certiorari was later denied by the Supreme Court
at 454 U.S. 965 (1981). The facts were remark
ably similar to the present case. The Carnation
company incorporated Three Flowers Assurance
Co., Ltd., a wholly owned Bermuda subsidiary.
Carnation then purchased a blanket insurance
policy from American Home Assurance Company.
At the same time Three Flowers, the captive insur
er, contracted to reinsure 90% of American
Home's liability under Carnation's policy. Ameri-
can Home paid to Three Flowers 90% of the
premium received from Carnation, less commis-
sion. It was part of this arrangement that Carna
tion, at the insistence of American Home, agreed
to capitalize Three Flowers up to $3,000,000. Car
nation deducted as a business expense the entire
premium paid to American Home. The Internal
Revenue Service decided that the 90% premium
ceded to Three Flowers was not deductible by
Carnation as a business expense. It treated it as a
capital contribution by Carnation to its subsidiary.
This ruling was upheld by the Tax Court and by
the U.S. Court of Appeals, and the U.S. Supreme
Court denied certiorari. The Court of Appeal
relied inter alia on the Helvering case and found
that similarly here there was no risk-shifting or
risk-distribution. While some emphasis was put on
the obligation assumed by Carnation to capitalize
Three Flowers up to $3,000,000, that does not
alter the principle which is equally applicable in
the present case: the principle being that there was
no risk shifted to anyone other than an instrumen
tality of the "insured" and that any gain or loss
experienced by the "insurer" would be that of the
"insured". It is of course also true in the present
case that the plaintiff through its wholly owned
subsidiary St. Maurice undertook to indemnify
Scottish and York, during the years that that
company was the plaintiffs insurer, for any losses
which Scottish and York might suffer as a result
of OI's failure to perform its obligations as a
reinsures. Also, the plaintiff itself guaranteed the
letter of credit, first for $500,000, and later for
$1,000,000, provided by OI to Scottish and York.
These arrangements reinforce the conclusion that
the ultimate risk remained with the plaintiff and
put its case on all fours with that of Carnation
during the years when the indemnity agreement
and the guarantee by the plaintiff existed. But I do
not consider the indemnity and the guarantee to be
essential to a finding that at no time during the
years in question was the risk shifted away from
the plaintiff or its instrumentalities.
Both the Helvering and the Carnation cases
were followed in Stearns-Roger Corp., Inc. v.
U.S., 577 F.Supp. 833 (U.S.D.Ct. 1984). In that
case the captive insurance subsidiary, Glendale
Insurance Company, was a U.S. subsidiary to
which the U.S. parent company paid premiums
directly. These premiums which were deducted by
Stearns-Roger as business expenses were disal
lowed by the Internal Revenue Service. The Dis
trict Court upheld the position taken by the Inter
nal Revenue Service. It cited with approval the
statement to the effect that the essence of insur
ance is a transfer of risk to an individual or a
corporation that is in the business of assuming the
risk of others. It went on to say, at page 838,
Here Glendale Insurance Company is not in the business of
insuring "others." Its only business is to insure its parent
corporation which wholly owns it and ultimately bears any
losses or enjoys any profits it produces. Both profits and losses
stay within the Stearns-Roger "economic family." In substance
the arrangement shifts no more risk from Stearns-Roger than if
it had self insured.
While in Canadian jurisprudence we have not
apparently embraced the term "economic family"
it appears to me we should reach the same conclu
sion, that in a case such as the present one the risk
has not been shifted to anyone other than an
instrumentality of the insured, an instrumentality
which draws all of its assets directly or indirectly
from the insured and whose only source of more
funds for paying insurance losses, should its assets
not be sufficient, would be the insured itself. With
out resorting to familiary metaphors, I can con
clude that such does not involve a true shifting of
the risk and therefore the payment of "premiums"
to such a captive "insurer" would artificially
reduce the income of the "insured".
In the Stubart case, Estey J. said at pages 576
S.C.R.; 6322 DTC:
It seems more appropriate to turn to an interpretation test
which would provide a means of applying the Act so as to affect
only the conduct of a taxpayer which has the designed effect of
defeating the expressed intention of Parliament. In short, the
tax statute, by this interpretative technique, is extended to
reach conduct of the taxpayer which clearly falls within "the
object and spirit" of the taxing provisions.
Parliament having specifically precluded in para
graph 18(1)(e) of the Income Tax Act the deduc
tion from income of amounts transferred to a
reserve fund, I cannot think it was Parliament's
intention that such a proscription should be cap
able of avoidance if the taxpayer can assemble a
sufficient array—one not normally available to
individuals or small businessmen—of advisers and
offshore management firms to create what, if in
legal form is an insurance scheme, is in reality a
reserve fund for repair or replacement of unin
sured property.
Some references were made by counsel for the
plaintiff to section 138 of the Income Tax Act
where there is a declaration as to certain corpora
tions being deemed to have been carrying on an
insurance business. I do not understand counsel to
be arguing that this section applies to OI, presum
ably because OI is not a taxable corporation oper
ating in Canada. Therefore I need not decide
specifically whether section 138 is inconsistent
with the foregoing. In my view, however, what I
have said above would equally apply to a captive
Canadian insurance corporation and in my view
paragraph 138(1)(a) would not apply to such a
corporation because it speaks of a corporation
which undertakes "to insure other persons against
loss". For the reasons which I have already given, I
do not think the kind of captive insurance arrange
ment in the present case is truly insurance.
It was also contended that under the "foreign
accrual property income" rules adopted in 1972
and put into effect in 1976, the income of such
offshore captive insurers is deemed to be the
income of the Canadian parent. It is therefore
implied that the law was otherwise prior to 1976
during the taxation years here in question. As I
understand it the "F.A.P.I." rules do not apply to
the situation with which I am dealing, namely the
deductibility of "premiums" from the parent's
income. Even if they did, however, this does not
necessarily mean that such amounts were exempt
from Canadian taxation if in the particular cir
cumstances they were deductions not permissible
under paragraph 18(1)(e) or subsection 245(1) of
the Act.
In reassessing the plaintiff's income, the Minis
ter, while disallowing the deductions for "premi-
ums" paid indirectly or directly to OI by the
plaintiff with respect to risks retained by OI,
allowed to be subtracted from the amounts disal
lowed the amounts actually paid out by OI with
respect to losses to the plaintiff's property. The net
effect was to reduce the plaintiff's income by that
amount. I confirm that that also was a correct
reassessment.
The Minister also attributed to the plaintiff
amounts earned by OI in interest and through
changes in the exchange rate with respect to the
funds in the possession of OI. While these funds
had their origin in the plaintiff, directly or in
directly, in my view any income or capital gains
arising from the holding of those funds by OI are
not attributable to the plaintiff. I see no reason
why the normal laws of property should not apply
here in the attribution of taxation, and these funds
and any other income it earned were the property
of OI which was a legal entity separate from its
parent, St. Maurice, and St. Maurice's parent, the
plaintiff company. It is one thing to say, as I have
done, that for a parent company to provide funds
for a wholly owned subsidiary of its wholly owned
subsidiary and then look to those funds for
replacement of uninsured losses is not risk-shifting
and therefore is not insurance. But it is quite
another thing to say that the income of a subsidi
ary is the income of the parent in the absence of a
specific rule so providing (as is now the case with
the F.A.P.I. rules in respect of offshore subsidiar
ies). Subsection 245(1) does not apply to the inter
est or exchange income of OI and in the absence of
a sham, which I have found not to exist here, the
normal distinctions between a parent and its sub
sidiaries should be observed: see, e.g. Fraser Com
panies Ltd. v. The Queen, [1981] CTC 61
(F.C.T.D.); The Queen v. Redpath Industries Ltd.
et al. (1984), 84 DTC 6349 (Que. S.C.); R. v.
Parsons (F.C.A.), supra. I therefore find that in
this respect the reassessment by the Minister is in
error so that there should be a reassessment which
does not attribute such revenues to the plaintiff.
The Minister's reassessments for the 1972 to
1975 taxation years are therefore referred back to
the Minister for reconsideration on the above bases
and on the bases set out in the "Partial Consent to
Judgment" filed at the trial on January 25, 1985
by counsel for both parties. Given the complexity
of the matter, I am requesting that counsel for the
defendant draft an appropriate judgment to imple
ment these reasons and, if possible, move for judg
ment under Rule 324 or otherwise under Rule 319.
The defendant being principally successful is
entitled to its costs.
You are being directed to the most recent version of the statute which may not be the version considered at the time of the judgment.