The tax court of Canada (TCC) has settled a long-standing dispute between mutual fund trusts and the Canada Revenue Agency (CRA) regarding GST charged on reduced management fees. In this case, the industry has walked away as the winner.

“For the mutual fund industry, this is a very big deal. It will save tens of millions of dollars,” says John Tobin, senior partner with Torys LLP in Toronto and co-counsel for Invesco Canada Ltd., the appellant in this case.

The seeds of this legal dispute were sown in 1995, when investment fund companies (including Invesco, an investment management firm headquartered in Toronto) changed the way they were offering a reduction in management fees to their large investors. Prior to this date, the discount to these investors had been paid in the form of a rebate. However, the Ontario Securities Commission and other regulators expressed concerns that the rebate approach could trigger double taxation: large investors might be compelled to pay taxes on both the money in the fund’s portfolio and also on the rebate cheque received from the fund, which the CRA might treat as a taxable “inducement payment.”

The CRA was asked for a technical interpretation and concluded that double taxation would result from the rebate process. In response, mutual fund trust companies such as Invesco changed their approach. They began charging large investors a reduced management fee and, in return, the funds agreed to distribute this reduction to large investors in the form of a “management fee distribution,” which the CRA ruled was not taxable.

While this new process put to rest concerns about double taxation, it raised another question: should GST be paid on the full amount of the management fee or on the reduced amount?

The CRA’s position is that the full management fee was always being charged, but to two different parties. The TCC decision describes the CRA’s position: “The respondent [the CRA] argued that the management fee distributions to the large investors did not represent a price adjustment for the management services that the appellant [Invesco] offered and, therefore, did not reduce the value of the consideration payable by the [investment] funds for the supply of the management services. There was no reduction in the total amount payable by the trust funds under the management agreement. The funds paid the full management fee but to two different parties.”

Therefore, the CRA argued, it should be allowed to collect GST on the full amount paid out by the trust – the fee paid to the fund manager and the management fee distributions paid to the large investors – and not just the final discounted fee rate negotiated with large investors.

As Bill Innes, tax lawyer with Rueter Scargall Bennett LLP in Toronto, noted in a comment on the case, the CRA’s position was “somewhat strained.”

The tax agency’s argument was unsuccessful. In Justice Diane Campbell’s decision in Invesco Canada Ltd. v. The Queen, the TCC judge found that the “reduced fee was the amount that was charged by the manager to the funds and it is the only transaction which is subject to GST.”

This decision also provides important guidance regarding contract interpretation. The TCC relied on Sattva Capital Corp. v. Creston Moly Corp., a decision issued by the Supreme Court of Canada last summer that endorses “a practical, common-sense approach to the interpretation of contracts not dominated by technical rules of construction,” according to Campbell.

At the time the GST dispute arose, many mutual fund trust companies were relying on contracts that were subsequently found to be open to interpretation, says Tobin: “Different documents used language that wasn’t as clear as it could have been.”

The TCC looked beyond the specific words to the understanding and the intent of the parties. “To this end,” Justice Campbell wrote, “a contract should be read as a whole, giving the words it employs their ordinary and grammatical meaning, consistent with the surrounding circumstances. Consequently, the Court must consider the commercial purpose, background and context of the transaction as well as the market in which the parties to a contract are operating.”

Today, most mutual fund trust companies have contracts that are unambiguous about the payment of fees. Since the onset of the Invesco legal action to resolve the GST issue, contracts have been “prettied up” and the language clarified, says Tobin.

“This decision will provide a measure of certainty to the industry that they will not be burdened by this additional GST,” says Innes.

Invesco is not alone in having been slapped with additional GST charges as a result of this distribution method. Now that the TCC has clearly upheld the mutual fund trusts’ approach, other companies involved in similar litigation may find that the CRA closes the books on their cases. “Hopefully, this will put the issue to rest,” says Tobin.

The CRA could appeal the decision to the Federal Court of Canada, or make a legislative change, but the tax lawyers interviewed by Investment Executive do not believe that is likely.

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