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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.


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

Federal Court of Appeal Reserves Judgment in Transalta Corporation v. The Queen (Allocation of Goodwill in Arm’s-Length Transaction)

The Federal Court of Appeal heard the appeal in Transalta Corporation v. The Queen (Court File No. A-350-10) on December 13, 2011 in Calgary. The panel consisted of Justices Evans, Layden-Stevenson and Mainville.

The case concerns the allocation to goodwill of $190 million of a $818 million purchase price paid by AltaLink LP (“AltaLink”) to Transalta to purchase an electricity transmission business.  The Tax Court (2010 TCC 375) partially upheld the application of section 68 of the Income Tax Act  (the “Act”) to re-allocate a portion of the amount allocated to goodwill to tangible assets, despite the fact that the goodwill amount was approximately the amount in excess of the amount that all parties accepted as the net book value of the business assets and working capital.

On appeal, the Crown maintained its argument that not everything that increases the price of a business above its net book value must be regarded as goodwill, since goodwill is a distinct asset of the business with a value.  The Crown argued that the owners of a business would not receive any additional benefit from items such as a skilled employee force.

Transalta argued that the Tax Court had erred by adopting a new test for goodwill as something other than the established residual definition, i.e., the value of a business in excess of its realizable assets.  The test adopted by the Tax Court would require undue and costly subjective analysis and would be commercially unworkable.  Furthermore, one side of a transaction would usually be unaware of the reasons that another party would pay an amount in excess of the realizable value of the business assets.

Transalta argued that where sophisticated arm’s-length parties have agreed to an allocation, for the purposes of section 68 of the Act, there should effectively be a shift of the onus to the Minister of National Revenue to demonstrate that the allocation was not reasonable.  Translta argued that the test for section 68 should be whether a reasonable business person would have agreed to the allocation, having only business considerations in mind.  This would extend the test in Gabco Ltd. v. The Queen (68 DTC 5210), which is well-established as the test for the purpose of section 67 of the Act.

At the conclusion of the parties’ submissions, the panel reserved judgment.

The taxpayer’s Memoranda of Fact and Law are here and here.

The Crown’s Memorandum of Fact and Law is here.

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Federal Court of Appeal Reserves Judgment in Transalta Corporation v. The Queen (Allocation of Goodwill in Arm’s-Length Transaction)

Federal Court of Appeal Affirms Tax Court Decision that Free Parking at School is a Taxable Benefit in the “Branksome Hall” Cases

On December 1, 2011, the panel of Justice John Maxwell Evans, Justice Carolyn Layden-Stevenson and Justice David Stratas of the Federal Court of Appeal heard the “Branksome Hall” parking cases (Geraldine Anthony, Heather Friesen, Leslie Morgan, Jarrod Baker v. The Queen (2011 FCA 336)). The appeals were dismissed with a unanimous judgment delivered from the bench by Justice Layden-Stevenson shortly after Appellants’ counsel concluded his oral argument.

As discussed in an earlier post, the appeals of four employees of Branksome Hall (a private school in Toronto) (the “Appellants”) were heard collectively as test cases and on common evidence. The Appellants and approximately 100 other employees of Branksome Hall were reassessed for their 2003 and 2004 taxation years to include $92 per month (inclusive of GST and PST) in their income, representing the value of free parking provided by their employer. The issues were whether parking provided to the Appellants by their employer was a taxable benefit under paragraph 6(1)(a) of the Income Tax Act (the “Act”) and, if so, how the value of that benefit should be assessed.

Counsel for the Appellants argued in his opening statement that this is a case of the Canada Revenue Agency casting its tax net as wide as possible and attempting to tax items that it had not taxed in the past. In response to this statement, Justice Evans noted that the Federal Court of Appeal is required to apply the law as prescribed under paragraph 6(1)(a) of the Act and not make any findings on the practices of the Canada Revenue Agency.

The Appellants’ submissions focused on Justice Brent Paris’ conclusion in the Tax Court of Canada that the value of the taxable benefit was its fair market value. They argued that fair market value should only be applied to cases where there is an open market to test competitive prices. Since the demand for parking at Branksome Hall only came from staff members and Branksome Hall was restricted from charging members of the public for parking as a result of zoning restrictions, there was no open market and, therefore, fair market value should not be applied. The Appellants submitted that the value of the taxable benefit should be determined by considering only the cost incurred by the employer to provide the benefit.

In delivering reasons for judgment on behalf of the panel, Justice Layden-Stevenson stated that the Court: a) agrees with the Tax Court’s finding that even if it is accepted that the parking benefit to the Appellants should be valued at Branksome Hall’s cost of providing the parking, the evidence adduced by the Appellants was not sufficient to prove what those costs were; b) rejects the argument that the fair market value is an appropriate method of valuation only when there is an open market for the benefit in issue; and c) finds that the Appellants’ argument has been overtaken by the decision of the Federal Court of Appeal in Spence v. The Queen (2011 FCA 200).

In Spence v. The Queen (2010 TCC 455), the Tax Court had valued an employment benefit of reduced tuition costs by using the cost approach instead of the fair market value approach. The Federal Court of Appeal reversed the Tax Court’s decision and applied the fair market value approach to the taxable benefit on June 13, 2011 – after the Appellants in the “Branksome Hall” cases had submitted their Memorandum of Fact and Law.

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Federal Court of Appeal Affirms Tax Court Decision that Free Parking at School is a Taxable Benefit in the “Branksome Hall” Cases

Federal Court of Appeal Affirms Tax Court Decision that Payment to Extinguish Employee Stock Option Plan is Capital Expenditure: Imperial Tobacco Canada Limited v. The Queen

On November 10, 2011, the Federal Court of Appeal (the “FCA”) delivered a unanimous decision in Imperial Tobacco Canada Limited v. The Queen, 2011 FCA 308. As discussed in an earlier post, the panel of Justice Marc Nadon, Justice Karen Sharlow and Justice Eleanor Dawson were asked to determine whether a one-time, lump sum payment of approximately $118 million made to employees to extinguish an employee stock option plan was a deductible expense or a payment on account of capital which is precluded from deduction by paragraph 18(1)(b) of the Income Tax Act (the “Act”).

The FCA dismissed the appeal of Imperial Tobacco Canada Limited (“Imasco”) and upheld Justice Bowie’s decision in favour of the Crown in Imperial Tobacco Canada Limited v. The Queen, 2010 TCC 648 noting that the decision of the Tax Court of Canada (the “Tax Court”) was “consistent with the evidence and the applicable legal principles.”         

Justice Sharlow found, notwithstanding the decision by Chief Justice Bowman of the Tax Court that a similar payment made in the course of the same series of transactions was fully deductible (Shoppers Drug Mart Limited v. The Queen), three factors that pointed to the conclusion that the payment was made on account of capital:

(i) the payment coincided with a reorganization of the capital of Imasco (the going private transaction and amalgamation);

(ii) the arrangements put in place for making the payment facilitated and were intended to facilitate the capital reorganization; and

(iii) the payment was intended to and did end all future obligations of Imasco to deal with its own shares, which can be described as a once and for all payment that resulted in a benefit of an enduring nature.

Justice Sharlow did acknowledge that there were two factors in favour of Imasco, namely, that (a) the employee stock option plan was entered into to provide a form of employee compensation and did make periodic cash payments for the surrender of options, and (b) the payment for the optioned shares represented only a small portion of the outstanding shares of Imasco (just over 1%).

In the end, the FCA followed its 1990 decision in Kaiser Petroleum Ltd. v. The Queen. Justice Sharlow agreed with Justice Bowie that the distinctions between the circumstances of Imasco and the facts in Kaiser were “distinctions without a difference”. Furthermore, the FCA rejected Imasco’s argument that Kaiser is not in step with current economic realities on the basis that it was decided at a time when employee stock option plans were not commonly used as part of the ordinary compensation package for employees of all levels.

In light of the significant difference in approach to the issue on substantially the same facts between the Federal Court of Appeal and Chief Justice Bowman in Shoppers, it would not be surprising if a leave application is filed with the Supreme Court of Canada.  As Justice Ian Binnie, formerly of the Supreme Court of Canada, noted in a recent interview, the function of counsel applying for leave is to kick the ball up in the air in an interesting way and the judges will grab it.”  That may very well be easier here than in many other tax disputes.

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Federal Court of Appeal Affirms Tax Court Decision that Payment to Extinguish Employee Stock Option Plan is Capital Expenditure: Imperial Tobacco Canada Limited v. The Queen

Federal Court of Appeal Hears Arguments in T1135 Penalty Cases: Judgment Reserved

A panel of the Federal Court of Appeal (Noël, Trudel and Stratas, JJ.A.) heard arguments this morning in Ottawa on appeals from judgments of the Federal Court which held that the Canada Revenue Agency acted reasonably in deciding not to cancel or reduce penalties and arrears interest on late-filed T1135 forms. See our earlier blog post for more information on the background to this case.

The Appellants’ main argument to the panel was that the Minister of National Revenue had improperly fettered his discretion in deciding that certain penalties and arrears interest should not be cancelled or reduced. In particular, the Appellants emphasized the fact that the CRA official, in his written reasons, held that the Appellants did not fit within the categories set out in the Taxpayer Relief Guidelines and thus that the Minister could not grant the request for relief. This, the Appellants argued, showed that the Minister did not appreciate or understand that he had unfettered discretion to provide relief. The Appellants argued, on the facts and with unfettered discretion, the reasonable conclusion would have been to grant relief.

Justice Stratas noted that on the reasonableness standard of review, a reviewing court may look to what might have been the reasons of the decision-maker.  In response, counsel for the Appellants responded that in Canada (Citizenship and Immigration) v. Khosa, the Supreme Court of Canada held that that what could have been the reasons of the decision-maker should not dilute the importance of giving reasons.

After putting the issue of “missing justification” to Crown counsel (who argued that cross-examination transcripts showed the CRA official had in fact considered all of the facts before him at the time), Justice Stratas wondered whether the CRA’s later justification was really just an exercise in bootstrapping. Members of the panel appeared concerned that taxpayers are obliged to file applications for judicial review simply in order to obtain an answer to their request for relief. Counsel for the Appellants argued that taxpayers “deserve the attention of the Minister” for their specific circumstances, given the nature of the discretion granted to the Minister under the Income Tax Act.

Justice Noël was interested in the fact that the Appellants failed to file the forms due to a common administrative error. Counsel for the Appellants described the policy objective underlying the penalty provision and argued that a multiplicity of penalties for what was actually just one common error would be disproportionate to the oversight by the taxpayers and would not advance the underlying purpose of the penalty. He argued that the existence of the common error should have had some significance to the exercise of the Minister’s discretion to cancel or reduce the penalties.

The panel reserved judgment.

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Federal Court of Appeal Hears Arguments in T1135 Penalty Cases: Judgment Reserved

Federal Court of Appeal Hears Arguments in CIBC World Markets Inc. v. The Queen: Judgment Reserved

On September 21, 2011, the Federal Court of Appeal (Sharlow, Layden-Stevenson, and Stratas, JJ.A.) heard an appeal by CIBC World Markets Inc. (“CIBC”) from a judgment of the Tax Court of Canada dismissing the taxpayer’s appeal of an assessment by the Minister of National Revenue under the Excise Tax Act.  For further details, see our earlier post.

The Appellant’s oral argument dealt with many of the points raised in the reasons for judgment of the Tax Court judge (Rip, CJ), specifically the interpretation of subsection 141.01(5) and section 225 of the Excise Tax Act.  Counsel for the Appellant was asked only a few questions from the bench during his submissions.

Counsel for the Respondent faced a number of questions from the panel.  Counsel for the Respondent argued that the Appellant had not adduced evidence to show that its revised input tax credit (“ITC”) allocation methodology was “fair and reasonable” within the meaning of subsection 141.01(5) of the Excise Tax Act.  The panel observed that the revised ITC allocation methodology had already been accepted by the Minister as a “fair and reasonable” method for subsequent years.  The panel was interested in hearing the Respondent’s submissions on what statutory basis exists in the Excise Tax Act precluding a taxpayer from using an alternative “fair and reasonable” allocation methodology in respect of prior years.

After a brief reply by Appellant’s counsel, the hearing concluded and the panel reserved judgment.

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Federal Court of Appeal Hears Arguments in CIBC World Markets Inc. v. The Queen: Judgment Reserved