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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

Out with the Old, In with the New: Clearwater Seafoods Holdings Trust v. The Queen

In the recent decision in Clearwater Seafoods Holdings Trust (2013 FCA 180), the Federal Court of Appeal considered the scope and purpose of Rule 29(1) of the Tax Court of Canada Rules (General Procedure) (the “Rules”).  When a trust ceases to exist during the course of a tax appeal, with tax liability shifting to a new person, may the new person continue the appeal?  The Court answered that question in the affirmative and unanimously held that this scenario falls within the language and intended purpose of Rule 29(1).

In 2011, Clearwater Seafoods Holdings Trust (the “Trust”) appealed an income tax assessment to the Tax Court of Canada.  In 2012, the Trust transferred all of its assets to Clearwater Seafoods Income Fund, which subsequently transferred the assets to Clearwater Seafoods Incorporated (the “Corporation”).  This transfer occurred in the context of the Trust “converting” to avoid application of the SIFT rules under the Income Tax Act.

At the Tax Court (2012 TCC 186), both parties accepted that the Trust had been terminated as a result of the disposition of all its property; however, this did not automatically bring the income tax appeal to an end.  The issue in Clearwater was whether the tax appeal could be continued with the Corporation as appellant in place of the Trust.  To obtain an order permitting the Corporation to assume the position of appellant going forward, a motion was brought by the Trust pursuant to section 29 of the Rules, which states,

29 (1) Where at any stage of a proceeding the interest or liability of a person who is a party to a proceeding in the Court is transferred or transmitted to another person by assignment, bankruptcy, death or other means, no other proceedings shall be instituted until the Registrar is notified of the transfer or transmission and the particulars of it. [emphasis added]

Once notice has been given to the Registrar, Rule 29 provides that the Chief Justice or a judge designated by him may direct the continuation of the proceeding.  At the Tax Court, the taxpayer brought a motion arguing that the Corporation is the appropriate party to continue the tax appeal as it now owned the property and would be liable if the appeal is unsuccessful.  The Crown argued that the tax appeal should be dismissed for want of an appellant.  The Tax Court held that the matter were not within the scope of Rule 29(1) and the motion was dismissed.  The order was appealed to the Federal Court of Appeal.

The Court of Appeal held that the lower court had construed Rule 29(1) too narrowly.  In arriving at this conclusion, the Court of Appeal addressed the rule’s underlying rationale.  The Court found that the purpose of Rule 29(1) is to deal with instances in which the circumstances of a litigant have changed and special accommodations are required in order to continue the proceeding.  Such changes may include bankruptcy, incapacity due to illness or injury, death of a litigant or the dissolution of a litigant that is a corporation.  The Court also considered such changes to include circumstances where a litigant that is a trust is terminated as a result of the disposition of all of its property.

The Federal Court of Appeal found that the transfer of the property to the Corporation, in effect, placed tax liability on the Corporation and the trustees in the event of an unsuccessful tax appeal.  The termination of the existence of the Trust was found to be within the meaning of “other means” in Rule 29(1).  Consequently, it was held that there was a transmission of liability from the Trust to “another person” by “other means”. The Court held that this scenario falls within the language and purpose of Rule 29(1).  As a result, the appeal was allowed and the matter was sent back to the Tax Court to be reconsidered with a view to directing the continuation of the proceedings.

The decision in Clearwater highlights the Court’s willingness to interpret Rule 29(1) in a broad manner.  It also raises the question of what constitutes “other means” for the purposes of Rule 29.  As a result, it is important for any taxpayer, or party which may acquire tax liability, to consider the implications of Clearwater prior to an income tax appeal.

Out with the Old, In with the New: Clearwater Seafoods Holdings Trust v. The Queen

Too Much Wiggle Room in Wigglesworth? Advisor penalties under Income Tax Act not criminal offences in nature and don’t engage protections under s. 11 of the Charter, says Federal Court of Appeal in Guindon

*This is the first guest post written for the blog. We are honoured to have one of Canada’s leading criminal defence counsel, Brian Heller of Heller Rubel, as the author (with the valued assistance of Graham Jenner).

On June 12, 2013, the Federal Court of Appeal released its decision in Canada v. Guindon (2013 FCA 153).

The court was tasked with examining the nature of advisor penalties, which are sanctions imposed under s. 163.2 of the Income Tax Act on tax planners engaged in “culpable conduct”. At first instance, the Tax Court of Canada (2012 TCC 287) had set aside one such penalty assessed against Ms. Guindon, holding that s. 163.2 created an “offence” within the meaning of s. 11 of the Charter. Consequently, according to the Tax Court, persons assessed under the provision were entitled to s. 11 protections, which apply to persons “charged with an offence”, and include fundamental principles applicable to criminal prosecutions such as the right to be presumed innocent, and the right to be tried within a reasonable time.

The key portion of s. 163.2 reads as follows, and it is easy to see how the Tax Court drew its particular interpretation:

(4) Every person who makes or furnishes, participates in the making of or causes another person to make or furnish a statement that the person knows, or would reasonably be expected to know but for circumstances amounting to culpable conduct, is a false statement that could be used by another person (in subsections (6) and (15) referred to as the “other person”) for a purpose of this Act is liable to a penalty in respect of the false statement.

The Federal Court of Appeal reversed the Tax Court’s ruling, first on the basis that Ms. Guindon had not followed the proper process in challenging s. 163.2, by failing to provide notice of a constitutional question, and so the Tax Court lacked the jurisdiction to make the order it did. However, the Federal Court of Appeal considered the merits of the issue in any event, and held that advisor penalty proceedings are not criminal in nature and do not impose “true penal consequences.”

The Federal Court of Appeal applied the test set down by the Supreme Court of Canada in R. v. Wigglesworth ([1987] 2 S.C.R. 541), which dictates that a provision will engage s. 11 Charter protections if (1) the matter is “by its very nature, intended to promote public order and welfare within a public sphere of activity” rather than being “of an administrative nature instituted for the protection of the public in accordance with the policy of a statute”; or (2) the provision exposes persons to the possibility of a “true penal consequence” such as imprisonment or a fine meant to redress wrong done to society.

The Federal Court of Appeal viewed advisor penalties for the provision of false information as an aspect of the self-compliance that is fundamental to the administration of the tax system. The penalties were not to condemn morally blameworthy conduct, but to ensure that the tax system works properly by maintaining discipline and compliance. Section 163.2 is also, the court observed, distinguishable from the clear offence provisions in the Income Tax Act because it contains only fixed sanctions rather than a range of penalties that allow for the exercise of judicial discretion in sentencing an offender.

The court also rejected Ms. Guindon’s argument that the sheer size of the penalty – in her case a fine of $564,747 – demonstrates the criminal nature of the sanctions, pointing to an array of cases in which very severe penalties were held to be administrative in nature. “Sometimes”, the court commented, “administrative penalties must be large in order to deter conduct detrimental to the administrative scheme and the policies furthered by it.”

If you have difficulty comprehending the distinctions that the Wigglesworth test draws between administrative and criminal provisions, you are not alone. The Federal Court of Appeal acknowledged that the line drawn by the test is “sometimes a fuzzy one”.

That is an understatement. At a time when substantial penalties can be leveled under provisions that appear to be aimed at protecting a public interest (such as the fair and proper administration of the tax system) by deterring culpable conduct, the Wigglesworth test is becoming increasingly difficult to apply. The difficulty is not limited to the sphere of tax law. Just one year ago, in Rowan v. Ontario Securities Commission (2012 ONCA 208), the Court of Appeal for Ontario had to apply the test to administrative monetary penalties (“AMPs”) under the Ontario Securities Act, which carry a maximum fine of $1,000,000. The court held that the specific fines at issue in that case were administrative rather than penal, but held also that s. 11(d) of the Charter limited the authority of the Securities Commission to impose AMPs that did not transgress the barrier from administrative to criminal. In other words, presumably, an overly severe AMP could, in the context of another case, indicate that the Commission had overstepped its regulatory mandate by imposing a truly penal consequence.

Rowan, then, demonstrates the difficulty and unpredictability of determining, under Wigglesworth, whether a specific sanction is penal or administrative. Guindon presents a related, but distinct practical problem: there exist provisions, such as s. 163.2 of the Income Tax Act, which can be described fairly as both intending to promote public order and welfare within a public sphere of activity (a criminal purpose) and intending to protect the public in respect of a policy of a statute (an administrative purpose). While advisor penalties clearly contemplate the promotion of tax policy objectives, they are equally concerned with persons who, through intentional conduct or willful blindness furnish false statements that are contrary to an important public interest. There is real concern raised by this case that a court can easily, using the language of Wigglesworth, justify opposite results. At the cost of certainty and predictability – important principles when constitutional protections are at stake – there is just too much ‘wiggle room’.

The narrow implication of Guindon is that unless the Supreme Court of Canada is called upon and reverses the result, the CRA will not have to govern itself by traditional criminal law standards in assigning culpability and sanctions for advisors. This could well have a chilling effect on the tax planning community. Speaking more broadly however, because advisor penalties straddle the “fuzzy” line between criminal and administrative law, Guindon is an ideal case for the Supreme Court of Canada to confront the practical unworkabilities of the Wigglesworth test.

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Too Much Wiggle Room in Wigglesworth? Advisor penalties under Income Tax Act not criminal offences in nature and don’t engage protections under s. 11 of the Charter, says Federal Court of Appeal in Guindon

Just as Intended: 1392644 Ontario Inc. et. al. v. The Queen

The role of intent in the determination of whether a worker is an employee or independent contractor has taken on greater significance in the last decade or so.

The Federal Court of Appeal has considered the role of intent in the classification analysis in Wolf v. The Queen, Royal Winnipeg Ballet v. The Queen, City Water International Inc. v. M.N.R., Combined Insurance Co. of America v. M.N.R.National Capital Outaouais Ski Team v. M.N.R., Kilbride v. The Queen and TBT Personnel Services v. M.N.R. 

In Lang and Lang v. M.N.R., Chief Justice Bowman of the Tax Court of Canada reviewed the underlying principles and stated that (i) intent is a test that cannot be ignored but its weight is as yet undetermined, and (ii) trial judges who ignore intent stand a very good chance of being overruled by the Federal Court of Appeal.

In the June 6, 2013 issue of Tax Topics, I discuss the Federal Court of Appeal’s recent decision in 1392644 Ontario Inc. et. al. v. The Queen, where the Court clarifies (i) the role of intent and (ii) the manner in which the classification analysis should be undertaken.

Just as Intended: 1392644 Ontario Inc. et. al. v. The Queen

Federal Court of Appeal strikes out a pleading alleging that expenses are non-deductible in light of “egregious and repulsive” conduct by a taxpayer

In a ruling handed down May 6, 2013, the Federal Court of Appeal ordered that portions of a Crown pleading be struck out for suggesting that a deduction may be disallowed on the basis that the conduct of the taxpayer in incurring the expense was “egregious or repulsive”.  Sharlow J. A. wrote the reasons in Canadian Imperial Bank of Commerce v. The Queen, 2013 FCA 122 in which Evans J.A. and Stratas J.A. concurred.

By way of background, the Canada Revenue Agency reassessed CIBC to disallow the deduction of some $3 billion of expenses incurred between 2002 and 2006.  The expenses at issue were incurred to settle litigation in the United States arising from losses suffered due to the collapse of Enron Corporation.  In the U.S. litigation, it was alleged that CIBC participated in the financing of Enron in a manner that made it liable to the complainants.

The Income Tax Act provides the formula for determining a taxpayer’s income for the year for income tax purposes.  Under paragraph 3(a), one component of a taxpayer’s income is income from a business of the taxpayer.  Under subsection 9(1), a taxpayer’s income for a year from a business is the taxpayer’s profit for the year from that business.

The most important limitation on the scope of subsection 9(1) is paragraph 18(1)(a) which provides:

18. (1) In computing the income of a taxpayer from a business […] no deduction shall be made in respect of

(a) an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business […];

In 65302 British Columbia Limited v. The Queen, a 1999 decision in which the deduction of a fine was allowed (later to be specifically disallowed by Parliament), Iacobucci J. of the Supreme Court of Canada made the following observation:

It is conceivable that a breach [of the law] could be so egregious or repulsive that the fine subsequently imposed could not be justified as being incurred for the purpose of producing income.

In the contentious part of its pleading, the Crown relied on that obiter statement and offered the following theory of non-deductibility of expenses:

134. The misconduct of [CIBC and its affiliates] was so egregious and repulsive that any consequential settlement payments […] cannot be justified as being incurred for the purpose of gaining or producing income from a business or property within the meaning of paragraph 18(1)(a) of the [Income Tax] Act. The [CIBC affiliates] knowingly aided and abetted Enron to violate the United States’ federal securities laws and falsify its financial statements. The misconduct of [the CIBC affiliates] in enabling Enron to perpetrate its frauds, known to [CIBC], or the misconduct of [CIBC] itself, was so extreme, and the consequences so dire, that it could not be part of the business of a bank.

The Crown’s contention, in a nutshell, was that an expense incurred due to conduct of the taxpayer that was “egregious or repulsive”, is precluded from deduction by paragraph 18(1)(a) of the Income Tax Act.

The CIBC asked the Tax Court of Canada to strike out that paragraph along with the other portions of the pleading reflecting the same theory.  The Tax Court chose not to do so.  The Federal Court of Appeal disagreed and struck out the contentious paragraph along with the related parts.

In dismissing the Crown’s argument, the Federal Court of Appeal emphasized that “the only question to be asked in determining whether paragraph 18(1)(a) prohibits a particular deduction is this: Did the taxpayer incur the expense for the purpose of earning income?”  The Court concluded by stating that the characterization of the morality of a taxpayer’s conduct is not legally relevant to the application of paragraph 18(1)(a) of the Income Tax Act.

Parties are generally given the opportunity to make whatever arguments they consider necessary to their case with the ultimate determination being made by the trial judge who is in the best position to decide questions of relevance and weight in light of all the evidence.  It is rather unusual for a legal theory, novel though it is, to be taken off the table at such an early stage.  At the same time, courts are increasingly concerned about “proportionality” and are reluctant to allow scarce judicial resources to be spent on matters that are unlikely to have any effect on the outcome of the hearing.  Whatever one’s view of the matter the Crown rarely seeks leave to appeal on procedural points, making it unlikely that this decision will be reviewed by the Supreme Court of Canada.

Notwithstanding the decision of the Federal Court of Appeal, the Crown will still be able to argue that the deductions taken by CIBC ought to be disallowed on a variety of other grounds including:

  • the deduction of the settlement payments does not accord with well accepted business principles;
  • the settlement payments were not made for the purpose of earning income from a business;
  • the settlement payments were outlays on account of capital;
  • the settlement payments were contingent liabilities when made; and
  • the amount of the settlement payments were not reasonable in the circumstances.

Although the taxpayer has prevailed in this battle, the war has just begun.

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This article was first published in the International Tax Review.

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Federal Court of Appeal strikes out a pleading alleging that expenses are non-deductible in light of “egregious and repulsive” conduct by a taxpayer

FCA provides guidance on role of intent in determining status of worker

The role of intent in the determination of whether a worker is an employee or independent contractor has taken on greater significance in the last decade or so. However, despite a series of decisions on the issue from the Tax Court and the Federal Court of Appeal, there appeared to be some inconsistency in respect of how and when intent was to be considered when applying the “four-in-one” test from Wiebe Door Services Ltd. v. The Queen ([1986] 3 F.C. 553) and 1671122 Ontario Ltd. v. Sagaz Industries Canada Inc. (2001 SCC 59).

In 1392644 Ontario Inc. (o/a Connor Homes) et al. v. The Queen (unreported; see court files 2010-948(CPP)I, 2010-949(CPP)I, 2010-950(EI)I, 2010-951(EI)I, 2011-237(EI)I, 2011-239(CPP)I, 2011-241(EI)I, 2011-242(CPP)I), the Tax Court held that several workers were employees of the appellant companies.

In the Federal Court of Appeal (2013 FCA 85), the taxpayers argued that the Tax Court judge had erred by (i) placing weight on the findings of fact made in other judgments involving the same appellants before the Tax Court, and (ii) not considering and misapplying the test for determining whether a worker is an employee or an independent contractor, particularly by not giving proper weight to the intention of the parties as expressed in their contracts.

On the first issue, the Federal Court of Appeal held that the lower court had noted that the facts in the present appeal were essentially the same as those considered previously in three separate appeals before three other judges of the Tax Court. However, in this case, the lower court judge had reviewed the parties’ evidence, weighed it, and reached his own conclusions based on it. Thus, there was no error committed by the lower court judge.

On the second issue – the role of intent – the Federal Court of Appeal noted the jurisprudential trend towards affording substantial weight to the stated intention of the parties (see, for example, Wolf v. The Queen (2002 FCA 96)Royal Winnipeg Ballet v. The Queen (2006 FCA 87)). However, the Court of Appeal noted, there was some difficulty in the application of the approach described in Wolf and Royal Winnipeg Ballet. The Court of Appeal emphasized that the parties’ may describe their relationship as they see fit, but the legal effect that results from the relationship is not to be determined at the sole subjective discretion of the parties. The Federal Court of Appeal stated:

[38] Consequently, Wolf and Royal Winnipeg Ballet set out a two-step process of inquiry that is used to assist in addressing the central question, as established in Sagaz and Wiebe Door, which is to determine whether the individual is performing or not the services as his own business on his own account.

[39] Under the first step, the subjective intent of each party to the relationship must be ascertained. This can be determined either by the written contractual relationship the parties have entered into or by the actual behavior of each party, such as invoices for services rendered, registration for GST purposes and income tax filings as an independent contractor.

[40] The second step is to ascertain whether an objective reality sustains the subjective intent of the parties. … the subjective intent of the parties cannot trump the reality of the relationship as ascertained through objective facts. In this second step, the parties’ intent as well as the terms of the contract may also be taken into account since they color the relationship. … the relevant factors must be considered “in the light of” the parties’ intent. However, that being stated, the second step is an analysis of the pertinent facts for the purposes of determining whether the test set out in Wiebe Door and Sagaz has been in fact met, i.e., whether the legal effect of the relationship the parties have established is one of independent contractor or of employer-employee.

The Court of Appeal noted that, in the present case, the lower court judge had proceeded in an inverse order (i.e., dealing with the parties’ intent at the end of his analysis). The Court of Appeal stated that the first step of the analysis should always be to determine the intent of the parties. However, despite the lower court’s inverse analysis, the judge had reached the correct conclusion regarding the status of the workers.

The Federal Court of Appeal dismissed the taxpayers’ appeals.

This is helpful guidance from the Federal Court of Appeal on the manner and stage at which intent should be considered when determining whether a worker is an employee or independent contractor.

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FCA provides guidance on role of intent in determining status of worker

Supreme Court dismisses leave application in Johnson v. The Queen

On March 21, 2013, the Supreme Court of Canada dismissed (with costs) the application for leave to appeal in the case of Donna M. Johnson v. Her Majesty The Queen.

The issue in Johnson was the tax treatment of receipts from a Ponzi scheme. The Tax Court (2011 TCC 540) allowed the taxpayer’s appeal and held that the receipts were not income from a source for the purpose of paragraph 3(a) of the Income Tax Act. The Federal Court of Appeal (2012 FCA 253) reversed the lower court’s decision, allowing the Crown’s appeal.

I commented on the decisions of the Tax Court and the Federal Court of Appeal in the March 2013 Ontario Bar Association Tax Section newsletter.

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Supreme Court dismisses leave application in Johnson v. The Queen

Federal Court of Appeal deals a blow to the Canada Revenue Agency: Full disclosure must be made on ex parte applications

On February 21, 2013, the Federal Court of Appeal released two decisions related to the obligations of the Minister of National Revenue when making ex parte applications under subsection 231.2(3) of the Income Tax Act (the “Act”) for judicial authorization requiring taxpayers to produce certain information and documents relating to customers.  In Minister of National Revenue v. RBC Life Insurance Company et al., 2013 FCA 50, the FCA affirmed the decision of the Federal Court (reported at 2011 FC 1249) cancelling four authorizations issued by the Federal Court in relation to customers of the Respondent companies who had purchased a particular insurance product that has been described as “10-8 insurance plans”.  In Minister of National Revenue v. Lordco Parts Ltd., the FCA adopted its reasoning in RBC and again affirmed a judgment of the Federal Court cancelling an authorization that had required information in respect of certain employees of the Respondent.

In both cases, the FCA reaffirmed the Minister’s “high standard of good faith” and the powers of the Federal Court to curtail abuses of process by the Crown.

In RBC, the Minister argued that the facts that it failed to disclose on its ex parte application before the Federal Court were not relevant to the applications. Reviewing the judgment of the Federal Court, the FCA concluded that the Minister failed to disclose the following facts:

  • The Department of Finance’s refusal to amend the Act;
  • Information in an advance income tax ruling;
  • CRA’s decision to “send a message to the industry” to chill the 10-8 plans; and
  • The GAAR committee had determined the plans complied with letter of Act.

The FCA held that the Federal Court’s finding that these facts were relevant was a question of mixed fact and law and the Minister had not demonstrated palpable and overriding error by the Federal Court judge. At a minimum, this suggests the Crown may have to disclose information of the sort included in the enumerated list.  Examining that list is interesting and suggests a requirement to include in the disclosure to the Federal Court judge hearing an ex parte application facts related to legislative history and intent including discussions about potential problems and possible legislative “fixes”, internal analysis of issues within the CRA including other advance income tax rulings, motivations on the part of the CRA and its officers and agents that may extend beyond auditing the particular facts, and previous analysis of the facts known  to the CRA and indications that those facts might support compliance with the Act and inapplicability of the GAAR.  That is a very extensive list, and it is encouraging to know that Crown obligations extend into each of these areas.

Further, the FCA held that even if the Federal Court on review of an ex parte order determined that the Minister had a valid audit purpose, it was open to the Federal Court to cancel the authorization based on the Minister’s lack of disclosure.  Somewhat surprisingly, the Minister argued that section 231.2(6), unlike section 231.2(3), did not allow for judicial discretion. Once the statutory conditions are established, the Minister argued, the Federal Court judge MUST NOT cancel the authorizations, no matter how egregiously the Crown acted.  The FCA rejected this argument, reaffirming the importance of judicial discretion and the duty of the Minister to act in good faith:

[26] In seeking an authorization under subsection 231.2(3), the Minister cannot leave “a judge…in the dark” on facts relevant to the exercise of discretion, even if those facts are harmful to the Minister’s case: Derakhshani, supra at paragraph 29; M.N.R. v. Weldon Parent Inc., 2006 FC 67 at paragraphs 153-155 and 172. The Minister has a “high standard of good faith” to make “full disclosure” so as to “fully justify” an ex parte order under subsection 231.1(3): M.N.R. v. National Foundation for Christian Leadership, 2004 FC 1753, aff’d 2005 FCA 246 at paragraphs 15-16. See also Canada Revenue Agency, Acquiring Information from Taxpayers, Registrants and Third Parties (issued June 2010).

The Minister’s argument, the FCA held, also runs contrary to the inherent power of the Federal Court to “redress abuses of process, such as the failure to make full and frank disclosure of relevant information on an ex parte application” (para 33):

The Federal Courts’ power to control the integrity of its own processes is part of its core function, essential for the due administration of justice, the preservation of the rule of law and the maintenance of a proper balance of power among the legislative, executive and judicial branches of government. Without that power, any court – even a court under section 101 of the Constitution Act, 1867 – is emasculated, and is not really a court at all. (para 36)

Overall, the RBC decision strongly reaffirms the role of the Federal Court in ensuring the Minister acts in good faith when making ex parte applications.  Given the broad powers granted in subsection 231.2(3) and elsewhere in the Act, it is reassuring to know that the Courts can, and will, protect taxpayers and citizens generally by ensuring that the CRA puts all relevant information before the Court when it seeks to exercise those powers.

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Federal Court of Appeal deals a blow to the Canada Revenue Agency: Full disclosure must be made on ex parte applications

A pointed observation by the Federal Court of Appeal on the CRA’s approach to proposed legislation

The recent Federal Court of Appeal decision of Edwards v. The Queen (2012 FCA 330) includes an interesting observation dealing with the Canada Revenue Agency’s policy with respect to proposed legislation.

In Edwards, the taxpayer was involved in a charitable donation scheme. Essentially, the taxpayer was able to obtain a charitable donation tax credit in an amount greater than his outlay or gift. The taxpayer was one of approximately 8,000 taxpayers that had been reassessed, and Edwards was the lead case for eight other appeals.

In the Tax Court, the taxpayer brought a motion for an adjournment of the hearing pending the enactment of proposed amendments to the Income Tax Act. The proposed amendments would be retroactive to when they were first announced. They may have allowed the taxpayer to claim all or a portion of the denied credit.

The CRA had been applying the proposed amendments as if they were law. However, the CRA refused to apply the amendments in the taxpayer’s case. The CRA took the view that the rules did not apply in his situation. As this was an administrative position on proposed amendments rather than law, the taxpayer could not challenge this decision.

The Tax Court denied the taxpayer’s adjournment request (2012 TCC 264).

The Federal Court of Appeal held that the motions judge made no error in denying the application for adjournment. At the time of the hearing of the motion it was not clear if the amendments would be enacted. However, the amendments were subsequently included in a bill to amend the Income Tax Act that received first reading on November 26, 2012. The Federal Court of Appeal found that this new information was a sufficient basis for reversing the motions judgment and granting the adjournment.

In obiter, Justice Evans noted that “there seems something fundamentally unfair in the CRA’s administration of proposed amendments to the Income Tax Act for the past ten years as if they were already law.”

Another example is proposed section 56.4. It has been in draft form since 2005. The proposed rule governs the tax treatment of restrictive covenants. As a matter of existing statute and case law, until proposed section 56.4 is enacted, it is arguable that restrictive covenants should receive the tax treatment described in case law such as the decision of the Federal Court of Appeal in Manrell v. the Queen (2003 FCA 128).

However, advisors and clients – mindful that the proposals will likely become law with retroactive effect – instead find themselves complying with legislative proposals that change over time and impose compliance burdens that are not clear. Proposed section 56.4 includes election provisions referencing prescribed forms that have not actually been prescribed. Taxpayers must satisfy themselves that they have provided sufficient supporting information, a matter over which the CRA retains discretion.

Sometimes the administration of proposed law for long periods of time becomes itself the subject of legislative proposals. For example, for close to a decade there were proposed changes to section 94.1, which deals with certain offshore investments. Ultimately, the proposed changes were withdrawn. Ironically, this has caused the need for new proposed legislation to provide a mechanism for relief for taxpayers who had complied with the unenacted original proposals.

Worse still, taxpayers and advisors must sometime rely only on press releases describing proposed legislation in arranging their tax affairs. For example, recent changes to rules respecting “stapled securities” were announced on July 20, 2011, with intended effect for some taxpayers one year from that date. The proposed legislation itself was released mere days after the intended effective date on July 25, 2012. To echo Justice Evan’s comments there seems to be something “fundamentally unfair” about the proposed laws a taxpayer must comply with being released days after compliance must begin.

It is hoped that the rather pointed remarks by Justice Evans lead to a review by the Department of Finance and the Canada Revenue Agency of this unsatisfactory state of affairs.

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A pointed observation by the Federal Court of Appeal on the CRA’s approach to proposed legislation

Federal Court of Appeal dismisses taxpayer’s appeal in Morguard: Trial judge made no error in concluding that a “break fee” was income

The Federal Court of Appeal has dismissed the taxpayer’s appeal in Morguard Corporation v The Queen.

(See our previous posts on the case here, here and here.)

Justice Sharlow wrote for the panel which also included Justice Evans and Justice Stratas.  She agreed with the reasoning of the trial judge that Ikea Ltd. v. Canada is indeed the leading case on the characterization of extraordinary or unusual receipts in the business context, and found that his application of the principles stated by the Supreme Court of Canada in Ikea was correct. The court noted that Ikea was not based on a particular factual finding, but “involved consideration of a number of factors, including the commercial purpose of the payment and its relationship to the business operations of the recipient.”

The Court of Appeal found that the trial judge made no error in concluding, on the facts of the case, that the break fee received by Morguard as the result of a failed takeover bid was income and not capital. The appeal was dismissed with costs.

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Federal Court of Appeal dismisses taxpayer’s appeal in Morguard: Trial judge made no error in concluding that a “break fee” was income

Federal Court of Appeal hears argument on whether “break fees” are income (Morguard)

Is a “break fee” received in return for withdrawing from a takeover bid a capital receipt or an income receipt?

That was the issue before a panel of the Federal Court of Appeal (“FCA”) on November 20, 2012 in Morguard Corporation v. The Queen on appeal from a decision of the Tax Court of Canada. The panel consisted of Justice Evans, Justice Sharlow and Justice Stratas. At the conclusion of the hearing, judgment was reserved.

For the facts of the case and our analysis of the trial decision, see here. For a brief review of the issues raised in the factum filed by each party in the FCA, see here.

Arguments of the Taxpayer

Counsel for the appellant argued the trial judge had made an “error of law” in determining that Acktion Corporation (“Acktion”) was “essentially in the business of doing acquisitions and takeovers” (Acktion was the name under which Morguard Corporation (“Morguard”) operated during the period at issue). Counsel argued that Acktion was a holding company and that it had sought the takeover to increase its capital holdings. The standard of review for an error of law is “correctness”.

The panel asked counsel whether there was any error of law. Justice Stratas asked whether the issue was really a factual one, for which the standard of review is much higher, namely, “palpable and overriding error”.

Counsel argued that it is settled law that a corporation cannot conduct a “business” of acquiring capital assets. Accordingly, counsel argued that the trial judge erred in concluding that Acktion had done so. In support of this proposition, counsel cited the 1978 FCA decision in Neonex International Ltd. v The Queen (78 DTC 6339). 

It was not clear whether the panel agreed with counsel on this point, as their other questions focused on whether the Supreme Court of Canada (“SCC”) decision in Ikea Ltd. v. Canada ([1998] 1 SCR 196) had displaced Neonex by instituting a “modern approach” that supports an organic assessment of the circumstances around the receipt.

Counsel argued the break fee was received in the pursuit of a capital acquisition and that, according to the modern approach, it should be characterised as a capital receipt. Counsel stressed that the expert evidence adduced at trial by both parties was that break fees are intended to support the acquisition of capital by deterring other bidders or to compensate for the various costs incurred in a failed takeover bid.

The panel sought clarification of the appellant’s position that there should be no tax liability arising from the receipt of the break fee. In its written submissions, the appellant argued that the break fee should not be taxed as a capital gain because there were no proceeds of disposition. Justice Sharlow noted that, according to this theory, the break fee could only be characterized either as income or a non-taxable capital gain.

Arguments of the Crown

Counsel for the Crown had to answer fewer questions from the panel. Counsel argued that the characterization of an “unusual receipt” such as a break fee requires a factual determination (relying on the SCC’s decision in Ikea on this point), which the Tax Court had made in this case.

Justice Evans asked about the distinction between conducting a real estate business that acquires companies as capital and being a real estate company in the business of acquisitions and takeovers. Counsel argued that, instead of acquiring real estate directly, Acktion’s business strategy was to acquire businesses that already owned real estate. Counsel further submitted that the corporate information distributed to its shareholders described the corporation as a real estate company and not as a holding company.

Justice Sharlow questioned the Crown’s reliance on the commercial description of Acktion’s business, noting that the technical distinction between income and capital is a legal distinction that would not generally be expected to appear in a commercial context. In response, counsel argued that Acktion treated the takeover bid as part of its regular business. After losing its takeover bid, Acktion negotiated a higher price for its remaining “toehold” in the company, then took the break fee and the proceeds of disposition of its shares and immediately sought to purchase another business. Counsel argued this course of conduct shows that Acktion considered the negotiation of break fees to be part of its real estate business.

In response to the appellant’s position that the break fee was a non-taxable capital gain, counsel submitted that the trial judge was correct in applying the factors set out by the FCA in Canada v. Cranswick ([1982] CTC 69) to determine whether a payment was a windfall. In this respect, the break fee was the product of an enforceable claim negotiated by the Appellant according to common practices in takeover bids and, thus, could not be characterised as a windfall.

*  *  *

The panel reserved judgment. We will report on the judgment when it is released.

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Federal Court of Appeal hears argument on whether “break fees” are income (Morguard)

Federal Court of Appeal to hear argument tomorrow in “break fee” case (Morguard)

Tomorrow morning (November 20, 2012), the Federal Court of Appeal is scheduled to hear an appeal by Morguard Corporation (“Morguard”, formerly operating as Acktion Corporation), regarding the taxation of a “break fee” received as a result of a failed takeover bid.

Break fees are an agreed-upon fee to be paid by or on behalf of a target corporation to a prospective purchaser on the rejection of that prospective purchaser’s bid and the acceptance of another offer. Break fees are intended to reflect, more or less, the monetary and non-monetary costs incurred by the prospective purchaser in making a bid, and are common in sophisticated takeover transactions.

The Morguard case concerns a $7.7 million break fee received by Morguard on withdrawal from a bidding war. In its return, Morguard treated the payment as a capital gain but was reassessed by the Minister of National Revenue on the basis that the amount was an income receipt. On appeal to the Tax Court of Canada, the trial judge agreed with the Minister’s position that, on the facts of the case, the break fee represented income and should be taxed accordingly. For our analysis of the Tax Court decision, see our earlier blog post.

The taxpayer has appealed the trial judge’s decision to the Federal Court of Appeal on the basis that the lower court erred in law and in fact. The Appellant has described the issues raised in the appeal as follows:

(a) Whether the trial judge erred in law by concluding that the taxpayer received the break fee on income account rather than capital account.

(b) If received on capital account, whether the break fee was received in circumstances that gave rise to a capital gain.

(c) Whether the trial judge made palpable and overriding errors in finding that the taxpayer was in the business of doing acquisitions and takeovers, and received the break fee in the ordinary course of its business similar to the receipt of dividends, rents, or management fees.

(d) Whether the trial judge made a palpable and overriding error in finding that the break fee was not linked to a capital purpose of the taxpayer.

(e) Whether the trial judge erred in law in his interpretation and application of the Supreme Court of Canada decision in Ikea Ltd. v. Canada [1998] 1 S.C.R. 196.

(f) Whether the trial judge erred in law by applying the legal test developed by the Federal Court of Appeal in The Queen v. Cranswick (82 DTC 6073) to break fees.

The Crown, on the other hand, has framed the issues as follows:

(a) Whether the trial judge committed a palpable and overriding error in finding that the negotiation and receipt of the break fee by the appellant was part of the ordinary course of its regular real estate business.

(b) Whether the trial judge was correct in concluding that the break fee should be included in the computation of the appellant’s income because it was received in the ordinary course of its business.

(c) Whether the trial judge correctly applied the jurisprudence to conclude that the break fee was not a windfall.

The Appellant’s factum is here. The Crown’s factum is here.

We intend to report again after the hearing in the Federal Court of Appeal.

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Federal Court of Appeal to hear argument tomorrow in “break fee” case (Morguard)

Crown Appeals Tax Court Decision in Guindon – Are Advisor Penalties “Criminal”?

On October 31, 2012, the Crown filed a Notice of Appeal with the Federal Court of Appeal against the judgment of the Tax Court of Canada in Julie Guindon v. The Queen (2012 TCC 287). In that decision, the Tax Court held that the advisor penalties imposed under section 163.2 of the Income Tax Act were criminal in nature, and therefore attract constitutional protection under the Canadian Charter of Rights and Freedoms. The Court also held that the standard of “culpable conduct” in section 163.2 was a higher standard than “gross negligence” as the latter has been interpreted in the context of subsection 163(2) penalties. For a more detailed review of the Tax Court decision, see our previous post here.

In particular, the Crown has appealed the Tax Court’s finding that the Charter applies to section 163.2 penalties, and the determination of the Court that “culpable conduct” is a different standard than “gross negligence”.

The advisor, who was found to have engaged in culpable conduct (and therefore would have been subject to the assessed penalty had the court not found the penalty to be criminal in nature) has yet to file a cross-appeal on that point.

Stay tuned to www.canadiantaxlitigation.com for further updates on this important appeal.

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Crown Appeals Tax Court Decision in Guindon – Are Advisor Penalties “Criminal”?

FCA: Trial court cannot ignore taxpayer’s evidence without good reason

The decision of the Federal Court of Appeal in Newmont Canada Corporation v. Canada delivered July 27, 2012 was primarily concerned with an unsuccessful attempt by the taxpayer to write off the principal amount of a large loan.  What makes the case quite interesting, however, is a side issue concerning the taxpayer’s claim to write off accrued interest on the loan.  That is where the Federal Court of Appeal parted company with the Tax Court of Canada and provided a useful reminder about the importance of evidence in tax appeals.

The interest in question arose in the 1988, 1989 and 1990 taxation years.  The CRA auditor allowed a portion of the interest expense:

[173]  During the course of the CRA audit, [the taxpayer] provided the CRA auditor, Mr. MacGibbon, with the details of the entries recorded in its general ledger account 2101 between August 1, 1989 and the end of May 1990. [The taxpayer] used this general ledger account to record amounts due from Windarra, including accrued interest on the Windarra Loan.

[174]  Mr. MacGibbon testified that [the taxpayer] did not provide him with any books or records for periods prior to August 1, 1989.

[175]  Based upon his review of the general ledger for account 2101, Mr. MacGibbon was able to identify entries totalling $183,336 that recorded interest income in respect of the interest accrued on the Windarra Loan. As a result, he allowed a deduction under subparagraph 20(1)(p)(i) in respect of the accrued interest.

While it is not clear why the earlier records were not produced, it is a reasonable inference that they were simply misplaced; they related to periods 20 or more years prior to the trial, which was held in 2009.

The taxpayer’s evidence was simple and direct:

[176]  The Appellant argued that the Minister understated the subparagraph 20(1)(p)(i) deduction by $156,888. It arrived at this number by performing the following calculation:

First, it determined the amount of accrued interest as at December 31, 1989 as follows:

a. The amount shown on the balance sheet at December 31, 1989 in respect of the Windarra Loan: $8.513 million

b. Less: the principal amount of the loan at December 31, 1989: $8.25 million

c. Equals the amount of accrued interest as at December 31, 1989: $263,000.

The Appellant then compared the $263,000 with the amount of interest income Mr. MacGibbon had calculated for the periods prior to 1989, namely $106,112.

[177]  It is the Appellant’s position that the difference between $263,000 and $106,112, which is $156,888, represents additional accrued interest income that was included in the income reported in [the taxpayer’s] 1988 and 1989 income tax returns.

[178]  During his testimony, Mr. Proctor summarized the Appellant’s argument as follows: “Because we have it on the balance sheet and, since debits must equal credits, it must have been on the Income Statement and we did not adjust it in arriving at net income for income tax purposes. For financial statement purposes it must be in the net income for income tax purposes.”

The Tax Court Judge rejected the taxpayer’s evidence:

[181]  I cannot accept the Appellant’s argument. [The taxpayer] could have recorded the offsetting amount as interest income. Alternatively, it could have recorded the offsetting amount on a balance sheet account such as a deferred revenue account or a reserve account. The only way to determine how the offsetting amounts were recorded in 1988 and the first half of 1989 would be to review the relevant books and records. Unfortunately, the relevant books were not provided to either the Minister or the Court.

[182]  The only evidence before the Court of accrued interest being included in [the taxpayer’s] income was in the working papers of Mr. MacGibbon. I agree with counsel for the Respondent that in order for the Appellant to obtain a deduction in excess of the amount allowed by the Minister “the Court should be presented with something more reliable than a conclusion based on unsubstantiated assumptions.”

Fortunately for the taxpayer, the Federal Court of Appeal held that there was no basis for the Tax Court Judge to reject the taxpayer’s evidence on the point:

[65]  Notwithstanding the auditor’s admission that it was likely that interest accrued in 1988 and the first part of 1989 in the Windarra Loan, the Judge rejected Mr. Proctor’s evidence that additional interest was included in [the taxpayer’s] income on the basis that [the taxpayer] “could have recorded the offsetting amount on a balance sheet account such as a deferred revenue account or a reserve account.” However, for the reasons that follow, there was, in my view, no evidence before the Court to support such a conclusion.

[66]  The Judge found Mr. Proctor to be a credible witness. Mr. Proctor testified that [the taxpayer] would have included the sum of $263,000 in its retained earnings. He reviewed the Reconciliation of Net Income for Tax Purposes form (i.e. the T2S(1) form) provided by [the taxpayer] for each of the 1988 and 1989 taxation years as part of its income tax returns (Appeal Book volume 2, pages 81 and 109) and identified no adjustments “in moving from financial statement income to net income for tax purposes relating to Windarra” (Appeal Book volume 7, page 1699).

[67]  With respect to the Judge’s reference to deferred revenue and reserve accounts, while [the taxpayer’s] 1988 and 1989 balance sheets did show a deferred revenue liability (Appeal Book volume 5, pages 1176 and 1181), the notes to its financial statements specified that the deferred revenue liability related solely to [the taxpayer’s] gold loan owed to a consortium of Canadian banks (Appeal Book volume 5, pages 1178 and 1188). The 1988 and 1989 balance sheets did not record any reserve accounts.

[68]  In this circumstance there was, in my respectful view, no evidence on which to impugn Mr. Proctor’s evidence, so that the Judge committed a reviewable error in rejecting the evidence for the reasons that he gave. Mr. Proctor’s evidence, together with the auditor’s concession established that [the taxpayer] had included the additional sum of $156,888 in interest income in its income tax returns.

[69]  It remained for [the taxpayer] to establish that the interest income was or became a bad debt. This required consideration of whether any monies paid to it pursuant to the Settlement Agreement were allocated to monies owing on account of interest. If so, that portion of the interest income would not be a bad debt.

[70]  Article 1(3) of the Settlement Agreement evidenced the parties’ agreement that the settlement proceeds were to be “applied on account of the principal amount of the [Windarra] Loan.” This established on a prima facie basis that all of the interest owing to [the taxpayer] pursuant to the Windarra Loans was a bad debt.

[71]  To conclude on this point, in my view, this Settlement Agreement combined with the evidence of Mr. Proctor and the auditor’s concession was sufficient to demolish the Minister’s assumption. Further, counsel for the Minister did not point to any evidence which rebutted [the taxpayer’s] prima facie case.

[72]  It follows that [the taxpayer] established its entitlement to deduct $156,888 under subparagraph 20(1)(p)(i) of the Act in 1992.

The case serves as a useful reminder about two important points.  First, the rules of onus are alive and well (as also discussed in my recent blog post on McMillan v. Canada).  Once a taxpayer has raised a prima facie case rebutting the Minister’s assumptions, the Minister cannot succeed unless Crown counsel can adduce additional evidence or otherwise undermine that prima facie case.

Second, and perhaps more important, the case demonstrates that solid evidentiary preparation and strong witnesses are critical if a taxpayer hopes succeed in the courts.  As it is exceedingly rare for the Federal Court of Appeal to overturn findings of fact made by a Tax Court Judge, every effort must be made to adduce evidence, both documentary and viva voce, in the Tax Court of Canada in order to maximize the likelihood of success both at trial and on appeal.

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FCA: Trial court cannot ignore taxpayer’s evidence without good reason

Canada’s Sommerer Decision and Double Taxation

A recent decision of Canada’s Federal Court of Appeal provides insight on the application of the country’s tax treaties to income that is attributed to a Canadian resident taxpayer under the Income Tax Act (Canada). Also, the court made useful comments on the classification of an Austrian private foundation (privatstiftung) for domestic Canadian tax purposes.

In Peter Sommerer v. The Queen, 2012 FCA 207, the court affirmed the decision of the Tax Court of Canada (2011 TCC 212) finding that gains realized on dispositions of shares by an Austrian private foundation were not taxable in the hands of an individual beneficiary of the foundation on the basis that either (a) the gains could not be attributed to the Canadian individual under the ITA’s attribution rules or (b) the capital gains article of the Austria-Canada Income Tax Convention of 1976, as amended, prohibited Canada from taxing the gains.

To read the full article by Jesse Brodlieb, Matthew Peters, and Tony Schweitzer, as published in Tax Notes International, Vol. 67, Number 6, August 6, 2012, please click here. For our earlier blog post on the decision, please click here.

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Canada’s Sommerer Decision and Double Taxation

Federal Court of Appeal: Canada Cannot Tax Treaty Income Twice

It is trite law that one of the main purposes of tax treaties is to prevent double taxation of the same income. In Canada this principle has often been treated with a grain of salt since Canadian domestic rules do not bar double taxation and, in fact, the Canada Revenue Agency often resorts to double taxation where, for example, a shareholder appropriation is disallowed as a corporate expense while fully taxed in the shareholder’s hands.

The recent decision of the Federal Court of Appeal in The Queen v. Sommerer illustrates a refreshing approach to the concept of double taxation, at least in the context of Canada’s network of bilateral tax treaties based on the OECD Model Convention (and, to a lesser extent, the UN Model Convention).

Mr. Sommerer was at all material times a resident of Canada. He was a contingent beneficiary of an Austrian Privatstiftung (the “Sommerer Private Foundation”) created by his father in 1996. The Sommerer Private Foundation was at all material times a resident of Austria for the purposes of the Canada-Austria Tax Treaty. The facts that gave rise to the assessments under appeal are summarized by Sharlow JA as follows:

[30] On October 4, 1996, Peter Sommerer sold to the Sommerer Private Foundation 1,770,000 shares of Vienna Systems Corporation (the “Vienna shares”) for their fair market value of $1,177,050 (66.5¢ per share). The Sommerer Private Foundation paid $117,705 of the purchase price on the date of the agreement and was legally obliged to pay the remainder at a later date, with interest. The sale was unconditional. The cash portion of the purchase price was paid using part of the initial endowment from Herbert Sommerer (paragraphs 67 and 88 of Justice Miller’s reasons).

[31] In December of 1997, the Sommerer Private Foundation sold 216,666 of the Vienna shares for $4.50 per share to three individuals unrelated to the Sommerer family, realizing a capital gain. In December of 1998, the Sommerer Private Foundation sold the remaining Vienna shares to Nokia Corporation for $9.00 per share, realizing a further capital gain.

[32] In April of 1998, Peter Sommerer sold to the Sommerer Private Foundation, unconditionally, 57,143 shares of Cambrian Systems Corporation (the “Cambrian shares”) for $100,000 (approximately $1.75 per share). In December of 1998, the Sommerer Private Foundation sold the Cambrian shares to Northern Telecom Limited for $14.97 (US) per share, plus a further $4.12 (US) per share conditional on certain milestones being met in 1999. That sale resulted in another capital gain for the Sommerer Private Foundation.

CRA assessed Mr. Sommerer on the basis of subsection 75(2) of the Income Tax Act alleging that the proceeds from the sale of the shares by the Foundation could possibly revert to Mr. Sommerer. Both Justice Campbell Miller in the Tax Court of Canada and Justice Sharlow in the Court of Appeal rejected that interpretation holding that subsection 75(2) could not apply on a sale of property at fair market value.

Justice Sharlow did not stop there however. She went on to agree with Miller J. that the position advocated by CRA violated the Treaty’s fundamental principle of avoiding double taxation:

[66] The OECD model conventions, including the Canada-Austria Income Tax Convention, generally have two purposes – the avoidance of double taxation and the prevention of fiscal evasion. Article XIII (5) of the Canada-Austria Income Tax Convention speaks only to the avoidance of double taxation. “Double taxation” may mean either juridical double taxation (for example, imposing on a person Canadian and foreign tax on the same income) or economic double taxation (for example, imposing Canadian tax on a Canadian taxpayer for the attributed income of a foreign taxpayer, where the economic burden of foreign tax on that income is also borne indirectly by the Canadian taxpayer). By definition, an attribution rule may be expected to result only in economic double taxation.

[67] The Crown’s argument requires the interpretation of a specific income tax convention to be approached on the basis of a premise that excludes, from the outset, the notion that the convention is not intended to avoid economic double taxation. That approach was rejected by Justice Miller, correctly in my view. There is considerable merit in the opinion of Klaus Vogel, who says that the meaning of “double taxation” in a particular income tax convention is a matter that must be determined on the basis of an interpretation of that convention (Klaus Vogel on Double Taxation Conventions: A Commentary to the OECD –, UN –, and US Model Conventions for the Avoidance of Double Taxation on Income and Capital, 3rd ed. (The Hague: Kluweer Law International, 1997)).

[68] I see no error of law or principle in the conclusion of Justice Miller that Article XIII (5) applies to preclude Canada from taxing Peter Sommerer on the capital gains realized by the Sommerer Private Foundation.

Unless this case is reversed by the Supreme Court of Canada (at the date of this comment, no leave application has been filed), it is likely to be a very important precedent for tax practitioners plying their craft in the highly complex area of international tax treaties.

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Federal Court of Appeal: Canada Cannot Tax Treaty Income Twice

Federal Court of Appeal Reaffirms the Onus of Proof Rules in Tax Appeals

In the recent case of McMillan v. Canada, the Federal Court of Appeal has reaffirmed the onus of proof rules in tax appeals. While the rules were never particularly unsettled at the federal level, the somewhat anomalous decision of the British Columbia Court of Appeal in Northland Properties v. The Queen in Right of the Province of British Columbia, appeared to cast doubt on prior Federal Court of Appeal pronouncements as well as the decision of Justice L’Heureux-Dubé in Hickman Motors Ltd. v. Canada. In Northland, the B.C. Court of Appeal took issue with the concept, articulated by Justice L’Heureux-Dubé in Hickman, that the onus was on the taxpayer to “demolish” the assumptions pleaded by the Minister by means of raising a prima facie case at which point the burden shifts to the Minister to prove the assumptions on the balance of probabilities:

[29] Before us, counsel for the Crown made persuasive submissions on the issue of the so-called “prima facie” standard: L’Heureux-Dubé J.’s use of “prima facie” was made in the context of a case in which the Crown had not called any evidence whatsoever; it was relying solely on its assumptions. It is certainly possible in such circumstances that a prima facie case, or even one with “gaps”, would be sufficient to displace the Crown’s assumptions, but the prima facie standard described by Justice L’Heureux-Dubé should not be interpreted as having altered the usual standard of proof in tax cases: see the comments in Sekhon v. Canada, [1997] T.C.J. No. 1145 at para. 37; and Hallat v. The Queen (2000), [2001] 1 C.T.C. 2626 (F.C.A.).

The facts in McMillan are uncomplicated and not particularly interesting. The taxpayer had a business in the Dominican Republic and claimed a number of expenses in connection with that business. The Tax Court denied most of the expenses claimed on the basis that they were not proven by the taxpayer. The taxpayer appealed to the Federal Court of Appeal and her appeal was dismissed on the basis that she did not demonstrate any material error on the part of the Tax Court judge.

The interesting part of the decision is the Federal Court of Appeal’s articulation of the rules relating to onus of proof in tax appeals:

[7] Before concluding these reasons, we note that the appellant did not raise in her memorandum of fact and law any issue with respect to the Judge’s statement at paragraph 19 of the reasons, and repeated at paragraph 21, that the appellant “has the initial onus of proving on a balance of probabilities (i.e. that it is more likely than not), that any of the assumptions that were made by the Minister in assessing (or reassessing) the Appellant with which the Appellant does not agree, are not correct.” In our respectful view, it is settled law that the initial onus on an appellant taxpayer is to “demolish” the Minister’s assumptions in the assessment. This initial onus of “demolishing” the Minister’s assumptions is met where the taxpayer makes out at least a prima facie case. Once the taxpayer shows a prima facie case, the burden is on the Minister to prove, on a balance of probabilities, that the assumptions were correct (Hickman Motors Ltd. v. Canada, [1997] 2 S.C.R. 336 at paragraphs 92 to 94; House v. Canada, 2011 FCA 234, 422 N.R. 144 at paragraph 30).

Thus, the Federal Court of Appeal has once again embraced the prima facie standard as the test that must be met by a taxpayer to displace or demolish assumptions pleaded by the Minister. While there may be a different standard applicable in provincial tax appeals in British Columbia, the reaffirmation of the prima facie standard by the Federal Court of Appeal is welcome news in federal tax appeals.

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Federal Court of Appeal Reaffirms the Onus of Proof Rules in Tax Appeals

FCA affirms the importance of GAAP in computing liability for LCT rejecting the Crown’s economic substance argument

The Federal Court of Appeal has once again affirmed the importance of Generally Accepted Account Principles (GAAP) in computing liability for the large corporation tax (LCT) applicable prior to 2006 while rejecting the Crown’s economic substance argument: The Queen v. Bombardier Inc.

The case turned on how Bombardier accounted for advances received in connection with long-term construction contracts:

[9] It can be seen from this agreement that the respondent has two divisions: the Aerospace Division (aircraft sale contracts) and the Transportation Division (public transportation equipment) and aircraft parts and components. It can also be seen that, in the Aerospace Division, as shown at paragraph 6 of the agreement, “[t]he income from contracts for aircraft sales is recognized as work progresses, on the basis of the delivery date, whereas in the Transportation Division, as shown in paragraph 10, “[i]ncome from long‑term contracts is recognized as work progresses, on the basis of costs incurred”.

[10] In summary, in the Aerospace Division, financing for long‑term work is obtained through advances of funds paid on dates predetermined in the contract of sale. The amounts of these advances do not depend on the work in progress or the work completed. They correspond to a portion of the selling price.

[11] Conversely, in the Transport Division, financing for work of the same nature is acquired through payments in amounts determined by progressive billing proportionate to the work completed.

In the case of aircraft sale contracts Bombardier used the “percentage-of-completion” method. The Crown did not dispute that this method was authorized by GAAP:

[27] The fact that the respondent’s balance sheet was GAAP‑compliant in all respects is recognized and acknowledged by the appellant and its expert. Indeed, the appellant’s expert, Mr. Thornton, confirmed this on cross‑examination. He also admitted that the respondent had correctly exercised its judgment regarding the advances, seemed to have applied standard SOP 81‑1 and had used paragraph 6.19 as a basis for its judgment; and that standard SOP 81‑1 was an acceptable source: see Mr. Thornton’s cross‑examination, Appeal Book, Vol. 10, at pages 109 to 114. He also acknowledged that the advances had been allocated to the project for which they had been paid, not used to finance other projects: ibidem, at page 117.

The Crown’s position was that in this case GAAP did not reflect economic reality:

[32] The appellant’s position, with which the Court of Québec agreed [a decision which is currently being appealed to the Québec Court of Appeal], gives precedence to the legal reality over the commercial and accounting reality by not allowing the amount of the advances to be reduced by the cost of the work for the purposes of calculating the taxable capital under paragraph 181(3)(b). According to the respondent’s expert, by designating the full amount of the advances as liabilities, the appellant is refusing to recognize that, on a commercial and economic level, the respondent used its inventory to perform the contract and sold that inventory, although from a legal standpoint ownership had not yet been transferred: see Mr. Chlala’s cross‑examination, Appeal Book, Vol. 9, at pages 40 to 43. In other words, the appellant’s position does not reflect the [translation] “economics of the situation” prevailing between the parties, which [translation] “suggest that a continuous sale occurs as the work progresses, and revenue should be recognized accordingly”: see the excerpt from the work by Messrs. Chlala, Ménard et al., quoted above in connection with the percentage‑of‑completion method.

The Court of Appeal rejected the Crown’s argument citing its earlier decision in Attorney General of Canada v. Ford Credit Canada Ltd.

In that decision Ryer JA wrote:

[27] In my view, this decision is far from helpful to the Minister in this appeal. In essence, Rothstein J.A. determined that the balance sheet of the taxpayer must be accepted for LCT purposes if it was accepted by the Superintendent of Financial Institutions. In my view, the same logic should apply where the corporation in question is subject to subparagraph 181(3)(b)(i) rather than subparagraph 181(3)(b)(ii). On that basis, provided that the balance sheet in question has been prepared in accordance with GAAP and otherwise complies with the specific provisions of Part I.3, that balance sheet must be accepted for the purposes of the determination of the LCT liability of the corporation.

While LCT decisions are of limited application to most taxpayers, this decision and the Ford Credit Canada Ltd. decision (where David Spiro was the successful lead counsel) form a useful bulwark against attacks mounted by the CRA based on “economic substance”.

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FCA affirms the importance of GAAP in computing liability for LCT rejecting the Crown’s economic substance argument

Further thoughts on the Fundy Settlement decision: Supreme Court offers a nuanced view of trust residence

In Garron Family Trust v. The Queen (2009 TCC 450), Justice Judith Woods of the Tax Court of Canada came down with a very broad new rule for determining the residence of trusts.

[162]  I conclude, then, that the judge-made test of residence that has been established for corporations should also apply to trusts, with such modifications as are appropriate. That test is “where the central management and control actually abides.”

This was viewed widely as a repudiation of the historic test based on the residence of the trustee. Many tax professionals thought that the test for residence of a trust required a determination of the residence of the majority of the trustees and where their functions were performed, and that it was not necessary to go beyond this test.

The Federal Court of Appeal in St. Michael Trust Corp. v. Canada (2010 FCA 309) appeared to endorse Justice Woods’ new legal test but in a somewhat guarded fashion:

[63]    St. Michael Trust Corp. argues that a test of central management and control cannot be applied to a trust because a trust is a “legal relationship” without a separate legal personality. I do not accept this argument. It is true that as a matter of law a trust is not a person, but it is also true that for income tax purposes, a trust is treated as though it were a person. In my view, it is consistent with that implicit statutory fiction to recognize that the residence of a trust may not always be determined by the residence of its trustee.

[64]    St. Michael Trust Corp. also argues that the residence of the trust must be determined as the residence of the trustee because section 104 of the Income Tax Act embodies the trust, as taxpayer, in the person of the trustee. In my view, that gives section 104 a meaning beyond its words and purpose. Section 104 was enacted to solve the practical problems of tax administration that would necessarily arise when it was determined that trusts were to be taxed despite the absence of legal personality. I do not read section 104 as a signal that Parliament intended that in all cases, the residence of the trust must be the residence of the trustee.

When the Supreme Court of Canada granted leave to appeal, some tax professionals were puzzled.  These tax professionals believed that it was unlikely the decision would be reversed since the Crown had a very strong factual case that the trusts in question were managed in Canada by the trust beneficiaries.  The decision released on April 12 by the Supreme Court (Fundy Settlement v. Canada, 2012 SCC 14) in fact dismissed the appeal in somewhat cursory fashion.

[15]    As with corporations, residence of a trust should be determined by the principle that a trust resides for the purposes of the Act where “its real business is carried on” (De Beers, at p. 458), which is where the central management and control of the trust actually takes place.  As indicated, the Tax Court judge found as a fact that the main beneficiaries exercised the central management and control of the trusts in Canada.  She found that St. Michael had only a limited role ― to provide administrative services ― and little or no responsibility beyond that (paras. 189-90).  Therefore, on this test, the trusts must be found to be resident in Canada.  This is not to say that the residence of a trust can never be the residence of the trustee.  The residence of the trustee will also be the residence of the trust where the trustee carries out the central management and control of the trust, and these duties are performed where the trustee is resident.  These, however, were not the facts in this case.

[16]    We agree with Woods J. that adopting a similar test for trusts and corporations promotes “the important principles of consistency, predictability and fairness in the application of tax law” (para. 160).  As she noted, if there were to be a totally different test for trusts than for corporations, there should be good reasons for it.  No such reasons were offered here.  [Emphasis added]

On a close reading it is arguable that the Supreme Court has gently tempered the new rule set out by Justice Woods and, to some extent, by the Federal Court of Appeal.  Where the trustee does what it is supposed to do, including managing the trust and its properties, the operative test remains the residence of the trustee.  It would seem that only where the trustee carries on those “management and control” activities in a place other than where the trustee is resident, or where the trustee abdicates many of its powers to a third party, that Justice Woods’ new test becomes relevant.

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Further thoughts on the Fundy Settlement decision: Supreme Court offers a nuanced view of trust residence

Public Foundation or Private Foundation? The Sheldon Inwentash and Lynn Factor Charitable Foundation v. The Queen

On February 29, 2012, the Federal Court of Appeal (“FCA”) heard oral argument in The Sheldon Inwentash and Lynn Factor Charitable Foundation v. Her Majesty the Queen (FCA Court File No. A-235-11). Pursuant to subsection 172(3) of Income Tax Act (Canada) (the “Act”), an appeal of the Minister of National Revenue’s decision to refuse charitable registration is made directly to the FCA.

The Appellant trust appealed the Canada Revenue Agency’s (the “CRA”) decision to refuse to register the Appellant as a “public foundation” within the meaning of subsection 149.1(1) of the Act. The Appellant was instead registered as a “private foundation” (For an excellent, if slightly out-of-date, discussion on the difference between private and public foundations, see Cindy Radu, “Public/Private Foundations – Issues and Planning Opportunities” in “Personal Tax Planning,” (2009), vol. 57, no. 1 Canadian Tax Journal, 119-142).

The definition of “public foundation”, as currently enacted, reads in part (underline added):

public foundation” means a charitable foundation of which,

(a) where the foundation has been registered after February 15, 1984 or designated as a charitable organization or private foundation pursuant to subsection (6.3) or to subsection 110(8.1) or (8.2) of the Income Tax Act, chapter 148 of the Revised Statutes of Canada, 1952,

(i) more than 50% of the directors, trustees, officers or like officials deal with each other and with each of the other directors, trustees, officers or officials at arm’s length, and

(ii) not more than 50% of the capital contributed or otherwise paid in to the foundation has been so contributed or otherwise paid in by one person or members of a group of such persons who do not deal with each other at arm’s length

[…]

Main Issue

The main issue on appeal is whether a trust with a single trustee can meet the “more the 50%” test in paragraph (a)(i). The basis for the CRA rejecting the Appellant’s application to register as a private foundation was that as there is only one trustee (being a registered trust company), which does not satisfy the requirement in subsection 149.1(1) of the Act that more than 50% of the directors, trustees officers or officials deal at arm’s length with each other.

The Appellant takes the position that the CRA has incorrectly interpreted the definition of public foundation. In short, the Appellant contends that the CRA is in error with respect to its position that a trust with a single trustee can never meet test in subparagraph (a)(i) of the definition.

The Appellant notes that the Interpretation Act, R.S.C. 1985, c I-21, as amended, provides that words in the plural include the singular (and words in the singular include the plural) and that Parliament could have easily drafted the legislation governing public foundations to provide for a minimum number of trustees, not dissimilar to the specified investment business and personal service business definitions which require a corporation to employ “more than five full time employees”. In the Appellant’s view, where a single, professional and arm’s length trust company is the sole trustee of a trust, the trust can still be public foundation pursuant to the definition in subsection 149.1(1), especially in light of the policy behind subparagraph (a)(ii), which the Appellant submits is to prevent the use of tax-exempt charitable donations for private gain.

The Appellant also contends that the CRA has not taken a consistent position on the application of this provision. Published CRA statements indicate that a trust requires at least three trustees in order to meet the test in subparagraph (a)(i). However, the Appellant points out that the CRA has approved as public foundations trusts with only two trustees. This position, according to the Appellant, cannot be reconciled with the CRA’s position on the “more than 50%” threshold, as two trustees by definition cannot satisfy such a requirement any more than can a trust with a single trustee.

The Crown’s position is that the definition of public foundation is clear and unequivocal, and should therefore be interpreted strictly in accordance with the Supreme Court of Canada’s decision in Placer Dome Canada Ltd. v. Ontario (Minister of Finance)[2006] SCR 715. A purposive approach, as suggested by the Appellant, cannot be used to supplant clear statutory language where there is no ambiguity.

Other Issues

The rule in subparagraph (ii) is commonly referred to as the “Contribution Test”. Pursuant to draft legislation released on July 16, 2010, the Contribution Test will be replaced by a rule whereby a foundation cannot be controlled by a person (or a group of arm’s length persons) who contributed more than 50% of the capital to the foundation (the “Control Test”). This legislation, once enacted, will have retroactive application to years after 1999.

According to the Crown’s Memorandum of Fact and Law, the CRA also refused to register the Appellant as a public foundation because, in the Crown’s view, both the Contribution Test and Control Test are not met. Interestingly, the Crown did not advance any argument on this final point in its written submissions, except to say that given the uncertainty that the proposed legislation will become law, the Appellant cannot seek registration on the grounds that it satisfies the Control Test. It is also interesting to note that the position taken by the Crown is contrary to the public position announced by the CRA by way of news release dated July 11, 2007 that it would administer the Act as though the Control Test applied.

The appeal was heard by a three-member panel of the FCA comprised of Madame Justice Eleanor Dawson, Madame Justice Johanne Trudel, and Mr. Justice David Stratas. Judgment was reserved.

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Public Foundation or Private Foundation? The Sheldon Inwentash and Lynn Factor Charitable Foundation v. The Queen