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CRA Rocks the Boat: Garber et al. v. The Queen

“Now then, Pooh,” said Christopher Robin, “where’s your boat?”
“I ought to say” explained Pooh as they walked down to the shore of the island “that it isn’t just an ordinary sort of boat. Sometimes it’s a Boat and sometimes it’s more of an Accident. It all depends”.
“Depends on what?”
“On whether I am on the top of it or underneath it”
A. A. Milne, Winnie-the-Pooh

Readers who were tax practitioners in the mid-80s will well remember the luxury yacht tax shelters, which were sold in 1984, 1985 and 1986 and which were one of the most popular tax shelters of that period. Many of us had clients who invested in this tax shelter and are aware that the CRA was very upset with this tax shelter and reassessed all of the investors. Tax practitioners from that period will also remember that the promoter of the tax shelter and several of his associates were prosecuted and convicted in connection with the luxury yacht tax shelter.

Approximately thirty years later, Associate Chief Justice Eugene Rossiter of the Tax Court of Canada released his decision in Garber et al. v. The Queen on January 7, 2014. The three appeals involved investors in limited partnerships which were established in 1984, 1985 and 1986 to acquire and charter luxury yachts and the deductions claimed by the Appellants in their 1984 to 1988 taxation years. The Appellants, as limited partners, claimed losses relating to the operation of the partnerships, interest deductions on promissory notes which were used to pay for the limited partnership units and professional fees paid in the year the Appellants subscribed for partnership units. The reasons for judgment note that 600 investors were reassessed and approximately 300 investors settled with the CRA.

The hearing opened on January 11, 2012 and in total over 62 days of evidence was given by 34 witnesses and there were 23 agreed statements of fact. The decision of Associate Chief Justice Rossiter is over 150 pages long and may rank as one of the longest Tax Court decisions (we previously commented on the length of the decision by Justice Boyle in McKesson Canada Corporation v. The Queen which was released in December 2013 – for those of you who keep track of such matters, this decision is fifty percent longer that the decision in McKesson.)

In basic terms, each of the Appellants invested in a limited partnership which was created to purchase a luxury yacht from the promoter. The promoter, as general partner, was committed to providing the yachts and to market and manage a luxury yacht chartering business for each limited partnership. The projections provided to the Appellants showed significant deductible start-up costs and the Appellants also expected to benefit from the tax depreciation (capital cost allowance) on the yachts. The Appellants’ investments were heavily leveraged with financing organized by the promoter and, therefore, a taxpayer who acquired a limited partnership unit would benefit from an attractive tax deduction in excess of his or her cash investment.

Associate Chief Justice Rossiter carefully reviewed the background facts relating to the limited partnerships (almost 100 pages are devoted to recounting the evidence). He noted that the promoter of the tax shelter and several of his associates were convicted of fraud in connection with the arrangement and found that the scheme was a fraud because virtually no yachts were acquired and the money paid by investors was used to promote future partnerships and not used in a yacht chartering business.

The CRA had offered numerous reasons why the expenses claimed by the Appellants should be disallowed:

  1. The limited partnerships did not constitute an income source under sections 3 and 4 of the Act because there was no genuine yacht charter business. The limited partnerships were not true partnerships because no actual business was carried out in common.
  2. The transactions were “mere” shams.
  3. Limited partnerships never actually incurred expenses for the purpose of gaining or producing business or property income.
  4. In the alternative, under subsections 9(1) and 18(9) of the Act, certain expenses incurred were not deductible in the years claimed because services were to be rendered after the end of the taxation year.
  5. In respect of interest payments, the CRA alleged that the promissory notes did not constitute actual loans and that no money was lent or advanced to the investors and, therefore there was no interest deductibility.
  6. To the extent any yacht was acquired by the 1984 partnership, capital cost allowance was restricted by the leasing property rules in subsections 1100(15), (17) (17.2) and (17.3) of the Income Tax Regulations.
  7. In the alternative, if interest was deductible, it would be limited by the half year rule in subsection 1100(2) of the Income Tax Regulations.
  8. For partnerships marketed in 1986, the partnership losses are restricted by the “at–risk” rules introduced on February 26, 1986.
  9. Subsection 245(1) of the Act is applicable because the expenses and disbursements claimed by an Appellant would unduly or artificially reduce the taxpayer’s income.
  10. The expenses are not deductible under section 67 of the Act because they were not reasonable and were not incurred to earn income.

After his extensive review of the evidence, Associate Chief Justice Rossiter analysed the legal issues. He found that there was no source of income for purposes of the Act under section 9 because the transactions were a fraud (similar to Hammill v. Canada, a 2005 decision of the Federal Court of Appeal) and because the scheme was a fraud, there was no source of income. It was noted that it is possible to have a fraud and a business (several cases are cited in this regard); however, based on the facts, in this situation, there was no business whatsoever. Therefore, there was no source of income.

One of the arguments made by the Appellants is that the significant amount of money received from investors was spent by the promoter and this indicates that there was a business. However, the facts were clear that money was not spent on acquiring yachts or a yacht charter business. Some of the funds were spent on unrelated endeavours and most of the funds were spent by the promoter on marketing and promoting future limited partnerships.

Associate Chief Justice Rossiter also noted that the Appellants commented during the trial on the “aggressive or inappropriate behaviour by members of the CRA”. He stated that his task “is not to assess the conduct of the CRA, but rather to determine whether or not the expenses claimed in these appeals are legitimate”. He also noted that the tax shelters were a Ponzi-like scheme which were set to collapse eventually and the conduct of the CRA did not turn the Ponzi-like scheme, which was a fraud from beginning to end, into a genuine business. In effect, all the CRA did was “lift the veil” to reveal the pervasive nature of the fraud.

Associate Chief Justice Rossiter also made clear that because the investment by limited partners was heavily leveraged, there was a lack of capital and this was a significant indication that there was no business being carried on.

Accordingly, there was no genuine business and the Appellants did not have a source of income from which they could deduct expenses or losses.

Furthermore, there were no genuine partnerships. For a partnership to exist, the parties must be a) carrying on a business b) in common and c) with a view to profit. Here, there was no business carried on; merely a fraud perpetuated by the promoter. Business was not carried on “in common” despite the existence of a partnership agreement because the promoter was perpetrating a fraud even though the limited partners were ignorant of the fraud perpetrated on them. As to a “view to profit”, there was no “view to profit”; the promoter had the intention to profit at the expense of the limited partnerships and the activities were so underfunded and so limited that there was no intention to profit.

Associate Chief Justice Rossiter went on to state that if there was a business carried on, the expenses claimed were not incurred for the purpose of operating the limited partnerships’ yacht chartering business and therefore were not deductible pursuant to subsection 18(1) of the Act.

Associate Chief Justice Rossiter also reviewed the requirement under subsection 18(9) of the Act that a taxpayer match any prepaid expense for services, interest, taxes, rent, royalty or insurance to the year in which those expenses relate. Based on the facts, the deductions claimed had little relation to actual expenses incurred and therefore deductibility is precluded under this provision.

Associate Chief Justice Rossiter also stated that in respect of one yacht which the taxpayers argued had been acquired by one of the 1984 partnerships, no evidence was presented that ownership of the boat was acquired by the limited partnership and therefore capital cost allowance was not deductible pursuant to paragraph 1102(1)(c) of the Income Tax Regulations. In any event, a boat was never acquired for income gaining or earning purposes and was only used by the promoter as window dressing to perpetrate the fraud.

In respect of the interest expenses claimed, the test under sub-paragraph 20(1)(c)(ii) was not met, because there was never a legal obligation to pay interest. The taxpayers entered into promissory notes based on fraudulent misrepresentations and any contractual obligation to pay interest would have been vitiated by the fraud.

In addition, in respect of the 1986 partnerships, the “at-risk” rules applied. It had been argued by the Appellants that the partnerships were grandfathered under the legislation but the statutory test for grandfathering had not been met.

Finally, any expense would have been denied under section 67 of the Act as the expenses were not reasonable in the circumstances if one considers the entire scheme. The Appellants had offered no evidence to show that expenses were legitimate or reasonable in light of services rendered or if any services were rendered at all.

Associate Chief Justice Rossiter concluded by stating that because of the lack of a source of income, the non-existence of genuine limited partnerships, the fact that the expenses were not incurred for business purposes, as well as the alternative arguments he addressed in his decision, it was not necessary to deal with all of the CRA’s arguments (e.g. sham and section 245). Accordingly, the appeals were dismissed with costs.

Given the amounts involved, and the number of taxpayers who were awaiting these decisions, it is likely that this case will “sail” into the Federal Court of Appeal.

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CRA Rocks the Boat: Garber et al. v. The Queen

The McKesson Case – A Holiday Gift from Justice Boyle of the Tax Court of Canada: Ask and You Shall Receive(able) – Canada’s Latest Transfer Pricing Decision

On Friday, December 20th, the Tax Court of Canada released the long-awaited and lengthy decision of Justice Patrick Boyle in McKesson Canada Corporation v. The Queena case involving transfer pricing adjustments under section 247 of the Income Tax Act (the “Act”) and the limitation period in Article 9(3) of the Canada-Luxembourg Tax Convention.

McKesson Canada is the principal Canadian operating company in the McKesson Group. The core business of the McKesson Group and of McKesson Canada is the wholesale distribution of “over the counter” and prescription pharmaceutical medicine products. Effective December 16, 2002 McKesson Canada and its Luxembourg parent company, MIH, entered into a Receivables Sales Agreement (the “RSA”) and a Servicing Agreement. Under the RSA, MIH agreed to purchase all of McKesson Canada’s eligible receivables as of that date (about $460,000,000) and committed to purchase all eligible receivables daily as they arose for the next five years unless earlier terminated as provided for in the RSA and subject to a $900,000,000 cap. The price to be paid for the receivables was at a 2.206% discount to their face amount (if one takes into account that historically receivables were paid on average within 30 days, this rate equates to an annual financing rate of approximately 27%). The Canada Revenue Agency reassessed McKesson Canada’s 2003 taxation year on the basis that if the RSA had been made between arm’s length parties the Discount Rate would have been 1.013% and made a transfer pricing adjustment under section 247 of the Act of $26,610,000 (the taxation year of McKesson Canada under appeal ended March 29, 2003 and was approximately three and a half months long – the annualized transfer pricing adjustment was therefore approximately $80,000,000).

The Tax Court trial lasted 32 days over a period of five months from October, 2011 to February, 2012 and following the Supreme Court of Canada’s decision in Canada v. GlaxoSmithKline Inc. in October, 2012, both parties made further written submissions.

Under the RSA, eligible receivables were trade receivables owing by arm’s length customers not in default and whose receivables would not represent in the aggregate more than 2% of McKesson Canada’s then outstanding receivable pool. However, the 2% concentration limit on eligibility did not apply to McKesson Canada’s largest customers who accounted for about one-third of the sales. MIH had the right to put non-performing receivables back to McKesson Canada for a price equal to 75% of the face amount to be later re-adjusted to the amount actually collected and MIH did not otherwise have recourse against McKesson Canada for unpaid purchased receivables. The receivables under the RSA were expected to be collected in a short period of time (historically, payment was made by customers in 30 days) and the historical bad debt experience was .043%.

Under the Servicing Agreement, McKesson Canada agreed to service the accounts receivable and received a servicing fee of $9,600,000 annually regardless of the amount outstanding. The amount paid under the Servicing Agreement was not challenged by the CRA.

The amount payable for a purchased receivable under the RSA was determined by multiplying the face amount of the receivable by one minus the Discount Rate. The Discount Rate was defined to be the sum of (a) the Yield Rate which was equal to the 30 day Canadian dollar banker’s acceptance (BA) rate or the Canadian dealer offered rate (CDOR) on the first business day of the relevant settlement plus (b) the Loss Discount which was intended to reflect the credit risk of the McKesson Canada customers whose receivables were covered by the RSA and was set at 0.23 for the year under appeal. For the remaining term of the RSA commencing January 1, 2004, the Loss Discount was to be recalculated as often as MIH considered necessary based on the credit risk of certain customers plus (c) the Discount Spread which was set at the fixed rate of 1.7305% and related to the risk that (i) McKesson Canada’s credit worthiness deteriorated significantly and receivable debtors might set off their rebate entitlements in such event, (ii) the risk that McKesson Canada’s customers might increase their take-up of available prompt payment discounts, (iii) the risk that MIH might decide to appoint a new service provider who would require a greater servicing fee, and (iv) the need for the Discount Rate to fully cover MIH’s cost of funds.

Toronto Dominion Securities Inc. (“TDSI”) was retained by counsel for McKesson Canada to provide advice on the arm’s lengths aspects of certain terms and conditions of the RSA and certain components of the Discount Rate calculation at the time the RSA was entered into. The TDSI reports were relied on by McKesson Canada as contemporaneous documentation and, therefore, a transfer pricing penalty under subsection 247(3) of the Act was not assessed by the CRA (had there been no contemporaneous documentation, McKesson Canada would have been automatically subject to a penalty of 10% of the transfer pricing adjustment). Interestingly, Justice Boyle states in a footnote that the CRA may need to review its threshold criteria in respect of contemporaneous documentation under subsection 247(4) of the Act and that he would not “have expected last minute, rushed, not fully informed, paid advocacy that was not made available to the Canadian taxpayer and not read by its parent would satisfy the contemporaneous documentation requirements.”

Justice Boyle stated that the CRA reassessment was made under paragraphs 247(2)(a) and (c) of the Act and that the task of the Court was to determine whether the terms and conditions of the transactions carried out by the parties resulted in a Discount Rate that was within the range of what McKesson Canada and MIH would have agreed to, had their transaction applied terms and conditions which persons dealing at arm’s length would have used. Interestingly, in light of recent OECD discussion papers, he noted that the CRA did not directly or indirectly raise “any fair share or fiscal morality arguments that are currently trendy in international tax circles” and that “it wisely stuck strictly to the tax fundamentals: the relevant provisions of the legislation and the evidence relevant thereto”. He noted that issues of fiscal morality and fair share are within the realm of Parliament.

Justice Boyle sets out in detail the evidence from the two material witnesses and the five expert witnesses who testified and criticizes much of the expert evidence. In respect of the transfer pricing report prepared by a major accounting firm in 2005 in response to the CRA’s review of the RSA transaction, he states that the report was primarily a piece of advocacy work, “perhaps largely made as instructed” and that the examples used by the accounting firm resulted in “picking and choosing” and mixing and matching the performance of the receivable pools which resulted in “transparently poor advocacy and even more questionable valuation opinions”.

Mr. Justice Boyle also criticized the taxpayer in respect of the manner in which the appeal was undertaken “Overall I can say that never have I seen so much time and effort by an Appellant to put forward such an untenable position so strongly and seriously. This had all the appearances of alchemy in reverse.”

In determining the appropriate methodology to determine the Discount Rate, Justice Boyle did not accept the conclusions of any of the experts or their reports in their entirety although he acknowledged that the Court’s analysis was informed by the testimony and information provided by the witnesses. He notes that the purpose of the RSA transaction was to reduce McKesson Canada’s Canadian tax liability by paying the maximum under the RSA that was justifiable (interestingly, McKesson Canada had been profitable for the years prior to the RSA but after the RSA was executed, McKesson Canada operated at a loss) and that there is nothing wrong with taxpayers engaging in “tax-oriented transactions, tax planning, and making decisions based entirely upon tax consequences (subject only to GAAR which is not relevant to this appeal)”. However, Justice Boyle also notes that the reasons for, and predominant purposes of, non-arm’s length transactions form a relevant part of the factual context being considered.

He then reviewed the various elements of the Discount Rate. In respect of the Yield Rate, he accepted that the 30 day CDOR rate is appropriate. However, for the period in question, he stated that it was necessary to review the historical evidence in respect of when payment would be made and that the parties should have taken into account the fact that the first period had a “missing” fifteen days because the agreement was entered into in the middle of the month. In respect to the Loss Discount which was fixed by the RSA at 0.23% Justice Boyle stated that this should be based on historical data which showed write-offs of approximately 0.04% and even if the parties provided a buffer of 50% to 100% increase in write-offs, the Loss Discount would be in the range of 0.6% to 0.8%. In respect of the Discount Spread, Justice Boyle looked at the various elements which were included in this number and based on the historical data and the facts provided, stated that the servicing discount risk would be in the range of 0.17% to 0.25%, the prompt payment dilution discount would be 0.5% to 0.53%, the accrued rebate dilutions discount (which involves a customer paying a lesser amount in respect of its accounts taking into account an expected rebate) was not justified and that the interest discount which was intended to provide MIH with a return from a discounted purchase of receivables would be between 0.0% and 0.08% for a total Discount Rate range of 0.959% to 1.17%. Accordingly, because the taxpayer did not rebut the CRA’s assumptions in respect of a reasonable Discount Rate, the taxpayer’s appeal in respect of the CRA’s transfer pricing adjustment was rejected.

The second issue reviewed by the Court involves the shareholder benefit and withholding tax on the deemed dividend which resulted from the excess amount paid by McKesson Canada to its Luxembourg parent MIH under paragraph 214(3)(a) and subsection 15(1) of the Act. By utilising a Discount Rate which was greater than an arm’s length rate, McKesson Canada provided a benefit to MIH which is to be treated as a deemed dividend and is subject to non-resident withholding tax and McKesson Canada was jointly liable with MIH for the withholding tax under subsection 215(6) of the Act. The taxpayer did not deny this liability but stated that it was statute-barred because the Canada-Luxembourg Tax Convention specifically provided for a five-year limitation period (Article 9 (3)) and the reassessment of McKesson Canada in respect of withholding tax was issued after this period. Justice Boyle held that because Article 9(3) of the Convention only deals with Article 9(1) of the Convention in respect of transfer pricing adjustments and not deemed dividends and because there was no evidence that MIH was subject to any “extra tax” in Luxembourg because of the deemed dividend, the five-year time limit in Article 9(3) does not apply and, therefore, the withholding tax assessed against McKesson Canada was not subject to the limitation period in the Convention. Therefore the taxpayer’s appeal in respect of withholding tax was also dismissed.

As noted above, the decision is a lengthy one (probably one of the lengthiest Tax Court decisions). In his final footnote, Justice Boyle apologizes for the length of the decision and quoting Lord Neuberger of Abbotsbury from a 2013 address, states:

“we seem to feel the need to deal with every aspect of every point that is argued, that makes the judgement often difficult and unrewarding to follow. Reading some judgements one rather loses the will to live – and that is particularly disconcerting when it’s your own judgment that you are reading”.

It will be interesting to see whether McKesson Canada decides to appeal this decision and if it does so, how Justice Boyle’s decision will be dealt with by the Federal Court of Appeal.

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The McKesson Case – A Holiday Gift from Justice Boyle of the Tax Court of Canada: Ask and You Shall Receive(able) – Canada’s Latest Transfer Pricing Decision

Supreme Court of Canada: Rectification is Alive and Well in Quebec

Earlier today, the Supreme Court of Canada delivered its decision in two Quebec rectification cases, Agence du Revenu du Quebec v. Services Environnementaux AES Inc. and Agence du Revenu du Quebec v. Jean Riopel. In a unanimous decision rendered by Mr. Justice LeBel (the only civil law judge on the panel) the Court upheld the decisions of the Quebec Court of Appeal in these two cases, permitting the parties to correct mistakes which resulted in unintended tax consequences. However, the reasons set out in Mr. Justice LeBel’s decision differ in part from the decisions of the Quebec Court of Appeal.

By way of background, Canada has a bijuridical legal system. The French civil law is the law in Quebec relating to civil matters while the law in the rest of Canada is based on the English common law. In these two cases, the issue related to whether rectification (which is a concept under the common law) can also be applied under Quebec civil law. It should be noted that the term “rectification” is not used in the reasons for judgment in either of the two appeals.

After going through the facts of each case and the decisions of the lower courts (see our previous posts on these cases here and here) Mr. Justice LeBel stated that the dispute between the taxpayers and the Quebec tax authority raises both procedural and substantive issues. He then went on to state that the substantive issue of whether proceedings to amend documents are permitted under Quebec’s civil law is the main issue and that the procedural issues are of only minor importance.

Mr. Justice LeBel noted that there was uncontested evidence establishing the nature of the taxpayers’ intention in each case and that under the civil law, in most cases a contract is based on the common intention of the parties and not on the written document. In this case, it was clear that the taxpayers’ intention was not properly documented because of the errors made by the taxpayers’ advisors. Accordingly, the taxpayers could rescind the contract or amend the documents to implement their intentions. In this case, the taxpayers had agreed to correct the documents so that the documents were consistent with their intentions.

The issue that then arises is to how such correction affects the tax authorities. Mr. Justice LeBel notes that in this case, there is an interplay of civil law and tax law and he makes the important point that the tax authorities generally do not acquire rights to have an erroneous written document continue to apply for their benefit where an error has been established and the documents are inconsistent with the taxpayer’s true intention.

Mr. Justice LeBel held that the parties in these two cases could amend the written documents because there was no dispute as to the intention of the parties and that it is open to the court to intervene to declare that the amendments to the documents made by the taxpayers were legitimate and necessary to reflect their intentions. He goes on to state that if a document includes an error, particularly one that can be attributed to an error by the taxpayer’s professional advisor, the court must, once the error is proved in accordance with the rules of evidence, note the error and ensure that it is remedied. In addition, the tax authorities do not have any acquired rights to benefit from an error made by the taxpayers in their documents after the taxpayers have corrected the error by mutual consent to reflect their intentions.

However, Mr. Justice LeBel warns taxpayers not to view this recognition of the parties’ common intention as an invitation to engage in bold tax planning on the assumption that it will always be possible for taxpayers to redo their contracts retroactively should the planning fail.

In the cases under appeal, the taxpayers amended the written documents to give effect to their common intention. This intention had clearly been established and related to obligations whose objects were determinative or determinable. Accordingly, the taxpayers’ amendments to the written documents were permitted.

Interestingly, the Attorney General of Canada, who intervened in the appeals, asked the court to consider and reject a line of authority that has developed since the Ontario Court of Appeal‘s decision in Attorney General of Canada v. Juliar, 2000 DTC 6589 (Ont. C.A.). Juliar is recognized as the leading case in rectification matters and has been the basis of numerous successful rectification applications in respect of tax matters in the common law provinces of Canada. Mr. Justice LeBel stated that the two cases under appeal are governed by Quebec civil law and it is not appropriate for the court to reconsider the common law remedy of rectification in connection with these appeals. Accordingly, Mr. Justice LeBel refrains from criticising, approving or commenting on the application of Juliar and rectification under the common law.

It is also interesting to note that in Juliar the CRA sought leave to appeal the decision of the Ontario Court of Appeal to the Supreme Court of Canada and that leave was denied. We will have to wait to see if the CRA attempts to take another case to the Supreme Court of Canada to determine the applicability of Juliar and rectification under the common law. However, it is now clear that Quebec taxpayers can now “fix” most tax mistakes if they can prove that their intention was to undertake a transaction which does not result in tax and the transaction does not involve “bold tax planning”.

Supreme Court of Canada: Rectification is Alive and Well in Quebec