In Brianne Gwartz v. The Queen, 2013 TCC 86, the Crown attempted to utilize the GAAR to recharacterize as dividends certain capital gains which had been realized by a family trust and allocated to the minor-aged taxpayers in 2003, 2004 and 2005.  The Crown argued that the transactions giving rise to the GAAR circumvented section 120.4 (the “kiddie tax”) which was amended in 2011 to apply to certain capital gains paid to minors.

The taxpayers conceded the existence of a “tax benefit” and an “avoidance transaction”, leaving the only issue being whether there existed “abusive tax avoidance”.  The Tax Court of Canada made some interesting comments about the application of the GAAR generally and specifically as it related to this case, the main points of which can be summed up as follows:

1      Tax planning is not inherently abusive for the purposes of ss. 245(4):  Taxpayers are entitled to plan their affairs in such a way that will minimize tax liability.  Choosing a course of action that minimizes the tax liability is not necessarily abusive [paras. 45 and 46].

2      GAAR cannot be used to fill in the gaps:  Abusive tax avoidance cannot be found to exist if a taxpayer can only be said to have abused some broad policy that is not in itself grounded in the provisions of the Act.  “[I]t is inappropriate, where the transactions do not otherwise conflict with the object, spirit and purpose of the provisions of the [Act] to apply the GAAR to deny a tax benefit resulting from a taxpayer’s reliance on a previously unnoticed legislative gap” [para 47].

3      There is no broad policy in the Act against surplus stripping:  In this case, the Crown contended that the taxpayers contravened the general policy against surplus stripping, but dropped this position at trial.  The Court noted that courts have held that surplus stripping does not inherently constitute abusive tax avoidance [para 50].

4      There is no broad policy in the Act against income splitting:  The Court noted that the increasing marginal tax rates and the choice to tax the individual as the basic taxable unit create incentives under the Act for taxpayers to split their income with their family members [para. 52]. 

5      The significance of subsequent amendments as an indicator of the policy underlying previous versions of a provision:  The Court noted subsequent amendments do not necessarily in themselves provide an indicator of some policy underlying the prior versions of a legislative provision.  Subsequent amendments must be considered along with all other relevant material to ascertain the object, spirit and purpose of the provision.  In certain circumstances, a subsequent amendment might suggest that the provision’s object or spirit were frustrated by the tax avoidance strategy. In other circumstances, it might suggest that Parliament simply changed its mind and now intends to prevent something that initially was not intended to be captured by the provision [para 57].

The Court ultimately allowed taxpayers’ appeals, finding that the object, spirit and purpose of section 120.4 of the Act were not indicative of a general policy against surplus stripping.  The Court held that the fact that specific anti-avoidance provisions were enacted at the time that 120.4 was enacted provided an indicator that Parliament was fully aware of the manner in which taxpayer’s could distribute corporate surplus.  Parliament’s exclusion of capital gains from section 120.4 was thus deliberately not intended to capture the transactions at issue.  In furtherance of this conclusion, the Court, by reviewing external evidence such as the 1999 Budget Plan and Notices of Way and Means Motions, found that the subsequent amendments to 120.4, which added only certain capital gains transactions, was evidence that “…Parliament decided not to cover capital gains when the measure was first enacted, and chose to do so on a prospective basis only in respect to a narrow subset of capital gains transaction.” [para. 74]

Since 1995, the Large Corporation Rules found in subsections 165(1.11), 169(2.1) and 152(4.4) of the Income Tax Act (Canada) have applied to discourage large corporations from objecting to tax assessments as a means of keeping tax years “open”. In Bakorp Management Ltd. v. The Queen, 2013 TCC 29, the Minister brought a motion to dismiss the corporation’s tax appeal on the basis that it failed to comply with the Large Corporation Rules. Basically, these rules require that an objection fled by a large corporation must reasonably describe each issue to be decided and, for each issue, must specify the relief sought as the amount of change in a balance. The rules also limit the issues and relief sought in a subsequent appeal to those set out in the objection. The locus classicus on the interpretation of these provisions is the decision of the Federal Court of Appeal in The Queen v. Potash Corporation of Saskatchewan Inc., 2003 FCA 471.

In Bakorp, the corporation owned shares of another corporation that were redeemed in 1992 for $338M. As the proceeds from the redemption were received over a number of years, Bakorp reported in 1995 the portion of the deemed dividend related to proceeds received in 1995. The Minister reassessed Bakorp’s 1995 tax year to reduce the deemed dividend from $53M to $25M, a reduction of $28M. The corporation objected to the Minister’s reassessment and the Minister confirmed the reassessment. The corporation then filed a Notice of Appeal taking the position that the $28M deemed dividend remaining in its 1995 income was actually received in 1993 and should be included in the corporation’s 1993 tax year, not the 1995 year.

The Minister was, no doubt, surprised by Bakorp’s position to reduce the 1995 deemed dividend to zero. In response, the Minister brought a motion to dismiss the corporation’s appeal, arguing that the issue and relief set out in the Notice of Appeal were not those set out in the Notice of Objection.

Bakorp argued that it had complied with the Large Corporation Rules because the issue in both its objection and appeal was, fundamentally, the amount of deemed dividend to be included in its 1995 income. The Court disagreed noting that it could not “imagine a fuller reconstruction than making a 180 degree turn in what is to be included in income.” In the Court’s view, applying such a general approach to identifying the issue would render the Large Corporation Rules meaningless. In respect of specifying the relief sought, the Court was not prepared to accept that a complete reversal from wanting $53M included in income to wanting nothing included in income could be seen as complying with the Large Corporation Rules.

As a notice of appeal has been filed with the Federal Court of Appeal, the Tax Court’s reasoning will not be the last word in this particular matter. However, it is safe to say that the Bakorp decision is a timely reminder that large corporations must take particular care in preparing a Notice of Objection. Failure to do so may seriously impact a later appeal to the Tax Court of Canada.

We’ve gone global . . . just like our clients. Today was our first day online at dentons.com giving you a “first look” at the impressive combination of SNR Denton, Salans and FMC to form Dentons. We now have more than 2,500 lawyers and professionals in 79 locations in 52 countries. What does this mean for our tax clients? We can help you access the right value-added tax expertise around the world, particularly when tax authorities in more than one jurisdiction are reviewing your affairs (e.g. simultaneous cross-border audits), when contentious issues arise with the Canada Revenue Agency or when you need to appeal to the Tax Court of Canada.

Questions? Just let us know.

A tax dispute with the Canada Revenue Agency may be an unwelcome and unpleasant experience for a taxpayer. In addition to the potentially complex tax issues, the dispute resolution process itself can be a nuanced and challenging process. However, an appeal to the Tax Court of Canada offers taxpayers a chance to have their disputes considered by “fresh eyes,” which could result in a victory, settlement or other efficient resolution.

In the March 15, 2013 issue of The Lawyers Weekly, I discuss some of the ways a tax appeal differs from a typical civil trial.

In Stanley J. Tessmer Law Corporation v The Queen, 2013 TCC 27, Justice Paris of the Tax Court of Canada confirmed that the general GST charging provision in section 165 of the Excise Tax Act, R.S.C. 1985, c. E-15 (the “ETA”) does not infringe section 10(b) of the Canadian Charter of Rights and Freedoms (the “Charter”).  Section 10(b) of the Charter provides:

Everyone has the right on arrest or detention

…

to retain and instruct counsel without delay and to be informed of that right;

The Appellant (“Tessmer”) provides criminal defence legal services.  During the period July 1, 1999 to December 31, 2006, Tessmer did not collect GST (totaling $228,440.97) in respect of legal services for criminal defence work charged to clients who had been arrested or detained and who were either charged with a criminal offence or who had been arrested with criminal charges pending.

Tessmer did not conduct an independent review of the financial circumstances of its clients to determine the ability of its individual clients to afford its fees and any GST exigible on those fees.  In addition, no financial records of any of Tessmer’s individual clients were produced at the hearing.

The Minister of National Revenue (the “Minister”) assessed Tessmer for such GST plus interest and penalty, and Tessmer appealed those assessments to the Tax Court.  In the context of those appeals, the parties decided to bring a reference to the Tax Court, pursuant to section 310 of the ETA, to determine the following question raised by Tessmer in its appeals:

Whether, based on the facts set out in the Agreed Statement of Facts filed herewith, the goods and services tax (GST) imposed by s. 165 of the Excise Tax Act infringes or is inconsistent with the rights of the Appellant’s clients guaranteed by ss. 7 and ss. 10(b) of the Charter of Rights and Freedoms such that s. 165 of the Excise Tax Act is, to the extent of any such inconsistency and, subject to s.1 of the Charter, of no force and effect by reason of s. 52(1) of the Constitution Act.

Although the question put to the Tax Court referred to both sections 7 and 10(b) of the Charter, Tessmer’s counsel advised the Tax Court at the hearing that he was only relying on section 10(b) of the Charter, and the above question was amended accordingly.

Subsection 165(1) of the ETA, the general GST charging provision, read as follows during the periods at issue:

Subject to this Part, every recipient of a taxable supply made in Canada shall pay to Her Majesty in right of Canada tax in respect of the supply calculated at the rate of 7% [note: 6% for the period between July 1, 2006 through December 31, 2006 – Ed.] on the value of the consideration for the supply.

Tessmer argued that a tax on criminal defence legal services provided to a person who has been arrested or detained is inconsistent with that person’s right under section 10(b) of the Charter to retain or instruct counsel of choice, on the basis that the tax is an impediment to the exercise of that right and is therefore unconstitutional with respect to both purpose and effect.  Relying on a U.S. case (United States v. Stein, SI 05 Crim. 0888 LAK United States District Court, Southern District of New York June 26, 2006), Tessmer argued that a tax on criminal defence legal fees will interfere with the right to counsel since the additional cost of the tax to an accused will interfere with the financial resources available to mount a defence to the charges brought against him or her.

Tessmer also argued that it was not required to provide evidence that any of its clients were denied counsel of their choice as a result of the tax imposed on the services of counsel.  Instead, and relying on a series of past Charter cases, Tessmer argued that it only needed to show that the general effect of the tax is unconstitutional under reasonably hypothetical circumstances.

The Tax Court, therefore, was required to determine whether either of the purpose or the effect of subsection 165(1) of the ETA was contrary to section 10(b) of the Charter.

With respect to the purpose of subsection 165(1) of the ETA, the Tax Court readily found that the purpose of that provision was not unconstitutional:

[31]        The appellant contends that the general purpose of the GST legislation imposing the tax is to raise revenue but that it also has a specific purpose to tax an accused with respect to the provision of legal services in defence of a State-sponsored prosecution. Its only submission regarding the unconstitutionality of the purpose of the tax was that it is patently inconsistent to prosecute a person and at the same time tax the legal services that the person requires in order to defend against the prosecution.

[32]        I am unable to ascribe the specific purpose suggested by the appellant to subsection 165(1) of the ETA, ….

[33]        Subsection 165(1) is a provision of general application and covers an infinite variety of transactions. I do not believe that it can be said that a specific purpose of subsection 165(1) is to tax legal services in defence of a State-sponsored prosecution since Parliament has not singled out those particular services for different treatment under that provision. Therefore I find that the appellant has not shown that subsection 165(1) of the ETA has an invalid purpose.

With respect to the effect of subsection 165(1) of the ETA, the Tax Court rejected Tessmer’s arguments that no evidence of an impediment to section 10(b) Charter rights was required.  The Tax Court stated, in relevant part, as follows:

[54]        From my review of the Supreme Court decisions on point, it appears that a party may only rely on hypotheticals to establish a factual foundation for a Charter challenge where actual facts are not available to that party. In such cases, the Court has been willing to consider imaginable circumstances which could easily arise in day-to-day life. ….

[55]        A party will also be relieved from presenting any factual foundation at all in cases where the unconstitutionality of the impugned legislation is apparent on the face of the legislation.

[56]        Apart from these limited exceptions, a party challenging legislation will be required to bring evidence of the effects of the legislation. Therefore, I reject the appellant’s contention that in any Charter challenge the Court may rely on imaginable circumstances to establish the effects of impugned legislation.

[57]        Furthermore, since the appellant does not take the position that evidence of the effect of the GST on the ability of its clients who were detained or arrested to afford its services is unavailable, I find that this case does not fall within the exception set out in Mills and implicitly recognized in Seaboyer/Gayme.

[58]        It is also obvious that the section 12 Charter standard of review which was applied in Goltz and Ferguson is not relevant to this case.

…

[64]        In response to the appellant’s submission that prejudice to a person’s section 10(b) rights must be presumed in this case, I can only say that I am unable to easily imagine that a person who has been arrested or detained would be prevented or even deterred from retaining and instructing counsel in that situation by the additional GST payable on counsel fees.

[65]        Finally, I do not accept the appellant’s contention that the constitutionality of the GST on criminal legal defence services is a question of law alone and therefore that it is not required to produce any evidence because it is apparent on its face that the tax will impede access to counsel.

Therefore, in the absence of evidence that any of Tessmer’s clients were unable to retain counsel as a result of the GST payable on legal services, the Tax Court found that the GST imposed under section 165 of the ETA does not infringe section 10(b) of the Charter.

Interestingly, the Tax Court hearing took place on December 15, 2011, and the decision was released on January 28, 2013.  Tessmer is still within the time limit to file an appeal with the Federal Court of Appeal, so it remains to be determined whether the Tax Court’s judgment remains the final word on this issue.

On December 20, 2012, the Tax Court ruled on a motion under Rule 52 of the Tax Court of Canada Rules (General Procedure) (the “Rules”) to require the Minister to comply with a demand for particulars specifying how the Income Tax Act (the “Act”) was abused in a General Anti-Avoidance rule (“GAAR”) case.

In Birchcliff Energy Ltd. v The Queen (2012-10887(IT)G), the Minister alleged that the GAAR should apply because the series of transactions (the “Transactions”) undertaken by the taxpayer resulted in a misuse of 10 sections of the Act and an abuse of the Act as a whole. In response, the taxpayer sought an order requiring the Minister to disclose the policy behind each section of the Act that was allegedly abused and how the Transactions abused that policy.

The Tax Court held that the Minister must disclose the object, spirit, and purpose of the provisions of the Act (the “Policy”) that the assessor relied upon in making the assessment. The Minister does not need to disclose the actual Policy that will be argued at trial, or the way that the Policy was abused.

Arguments

The taxpayer argued that in making a GAAR assessment, the Minister must assume as a fact the Policy and an abuse of that Policy. Relying on Johnston v M.N.R. (1948 S.C.R. 486), the taxpayer argued that the Crown had a duty to disclose “precise findings of fact and rulings of law which have given rise to the controversy”. The taxpayer also argued that there was a heightened obligation on the Minister to be specific in cases of misconduct, negligence, or misrepresentation, relying on Chief Justice Bowman’s decision in Ver v Canada ([1995] T.C.J. No. 593). Misuse or abuse, it was argued, belonged in the category of offenses requiring more precise disclosure.

The Minister, on the other hand, argued that the Policy was a conclusion of law, not fact and that only allegations of fact must be disclosed in particulars. The Minister raised a “slippery slope” argument, suggesting that this ruling could require the Crown to explain its legal interpretation of all provisions of the Act in the future. Although the Minister acknowledged that Trustco v Canada (2005 SCC 54) placed the burden of identifying the Policy on the Crown, that burden did not apply to pleadings. The Minister also argued that disclosing the Policy would not help the Appellant because the Minister could still argue a different policy at trial.

Decision

The Tax Court highlighted the unique nature of GAAR, and stated that any disclosure requirements from this case would only apply to GAAR assessments. Justice Campbell Miller specifically pointed to the Crown’s burden to prove the Policy in GAAR cases as evidence of its unique requirements.

Justice Miller separated the elements of the Policy into two distinct categories:

1)      The actual Policy that would be argued and decided at trial (the “True Policy”), and

2)      The fact that the Crown relied on a particular Policy when determining that GAAR should be applied (the “Historical Policy”).

The Court held that the True Policy was a question of law that should ultimately be decided by the court. This policy was open to change throughout the course of litigation and did not need to be disclosed to the Appellant at this stage.

The Historical Policy, however, was held to be “a material fact, not an assumption, but the fact the Minister relied upon x or y policy underlying the legislative provisions at play in the case.” Taxpayers are entitled in pleadings to know the basis of the assessment. Disclosing the Historical Policy would be similar to disclosing the legislation upon which non-GAAR assessments are made. The Court distinguished the Historical Policy from the type of materials to which the taxpayer was denied access in Mastronardi v The Queen (2010 TCC 57), a recent Tax Court decision holding that the Minister did not need to disclose the extrinsic materials on which the Minister relied in determining the Policy. In Mastronardi, the materials sought to be disclosed were evidence that could be used to prove the policy, rather than the material fact of which policy was relied on (evidence itself is not a material fact).

The Historical Policy that must be disclosed is not the Policy of each identified section in isolation. The Minister must identify the collective policy of all of the identified provisions together that the Crown relied on in making the assessment. The Historical Policy should be disclosed under paragraph 49(1)(e) of the Rules as “any other material fact”.

With regards to the Appellant’s request for information on how the Policy was abused, the Court held that it was not required to be disclosed. Abuse is a conclusion of law to be determined by the court based on the Policy and the facts of the case. The Minister did not assume how the Policy was abused as a fact. The Minister concluded, based on the Policy and the facts assumed, that there was an abuse.

*  *  *

The Tax Court has reiterated that the taxpayer is entitled to know the basis of the assessment made against him.  Such an approach is consistent with principles of fundamental fairness and is entirely in keeping with the letter and spirit of the Rules.

In Noran West Developments Ltd. v. The Queen, the Tax Court of Canada (Justice Brent Paris) upheld the validity of a taxpayer’s waiver of its right to appeal executed following the conclusion of a settlement with the Appeals Division of the Canada Revenue Agency (the “CRA”).  This conclusion was reached, and the Crown’s motion to quash granted, notwithstanding the taxpayer’s valiant attempts to set aside the agreement.

The relevant statutory provision in subsection 169(2.2) of the Income Tax Act:

Waived issues

(2.2) Notwithstanding subsections 169(1) and 169(2), for greater certainty a taxpayer may not appeal to the Tax Court of Canada to have an assessment under this Part vacated or varied in respect of an issue for which the right of objection or appeal has been waived in writing by the taxpayer.

By way of background, the CRA audited a corporate taxpayer (the Appellant) in respect of unreported income from a condominium joint venture which engaged in certain non-arm’s length dispositions.  The auditor reassessed to (a) include $640,000 in the taxpayer’s income for its 2005 taxation year (on the basis of a valuation of the relevant condominium units), (b) recognize a shareholder benefit to the taxpayer’s sole shareholder and (c) apply gross negligence penalties under subsection 163(2) of the Income Tax Act in respect of both reassessments.

The taxpayer filed a notice of objection objecting to the inclusion of the $640,000 in its income (on the basis that the CRA’s valuation was wrong) and the assessment of a subsection 163(2) penalty.  The taxpayer’s sole shareholder filed no objection against his own reassessment.

Following discussions with the taxpayer’s representative, the Appeals Officer offered to settle the matter by (a) reducing the income inclusion by $50,000 (on the basis of a reduced valuation of the relevant condominium units) and (b) reducing the amount of the subsection 163(2) penalty accordingly.  The Appeals Officer sent a standard waiver letter which was signed by the taxpayer’s sole shareholder on behalf of the taxpayer.  It included the usual language in which the signatory attests that he or she is ”familiar with subsection 165(1.2) and 169(2.2) of the Income Tax Act and understand that I will be precluded from filing an objection or an appeal with respect to those issues.”

The CRA reassessed to implement the settlement, but the taxpayer filed an appeal in Tax Court in response.  The Crown moved to quash the appeal on the basis that the taxpayer had waived its right to appeal under subsection 169(2.2) of the Income Tax Act.  In answer to the motion counsel for the taxpayer advanced six arguments, none of which were successful:

1. The waiver agreement was not “in writing” as required by subsection 169(2.2) as the Appeals Officer omitted the taxpayer’s name.

The Tax Court judge concluded that “waived in writing” simply “requires that a waiver be reduced to writing as opposed to one given orally” and proceeded to find that the waiver agreement could not reasonably be read as applying to anyone other than the taxpayer.

2. The waiver agreement is unenforceable as the reassessment contemplated by that agreement would not have been consistent with the facts and the law.

The Tax Court judge found that there were errors in the first reassessment (the one that was settled).  However, the reassessment before the Court was the second reassessment (the one issued as a result of the waiver agreement).  As the second reassessment simply reduced the taxpayer’s income by $50,000 and reduced the subsection 163(2) penalty accordingly, there was no question that such a reassessment is within the CRA’s power.

3. The waiver agreement is invalid because the parties were not ad idem as to the terms of the agreement.  

First, it was said that the taxpayer’s sole shareholder believed that the waiver agreement applied to three taxpayers, not just one.  Therefore, there was no “meeting of the minds”.  Unfortunately for the taxpayer, the judge found that that belief, on the evidence, was “highly unlikely”.  In addition, an adverse inference was drawn from the failure of the taxpayer’s representative to give any evidence at all about what happened at the appeals stage.  The judge also rejected the contention that the sole shareholder believed that issue of beneficial ownership of the condominium units wasn’t covered by the waiver agreement and, therefore, there was no consensus ad idem.  There was no ”beneficial ownership” issue raised in the Notice of Objection, so there could be no reasonable expectation that it would have been reflected in the agreement.  The taxpayer’s final contention was that the sole shareholder did not believe that the waiver agreement dealt with the subsection 163(2) penalty.  As the text of the agreement dealt with the penalty, Justice Paris concluded that:

[61] . . . [i]f a party chooses not to read an agreement with care before signing it, or chooses to skip reading parts of it, I fail to see how he can turn around and allege that his intention did not accord with the written agreement. It must be presumed that, in those circumstances, the party intended to accept the agreement as written.

4. The agreement was vitiated by the CRA as it did not satisfy the terms of the waiver agreement because the subsection 163(2) penalty was incorrectly calculated on the second reassessment. 

Here is the error:

[24]  The respondent’s counsel concedes that an error was made in calculating the amount of the gross negligence penalty in the [second] reassessment and that the penalty was based on unreported income in the amount of $599,760 rather than on $589,760, as agreed. The respondent concedes that the penalty was too high by as much as $1,106. Because this error was only raised by Noran’s counsel shortly before the hearing of the motion, counsel for the respondent advised the Court that she was unable to obtain the exact amount of the error.

The Tax Court judge found himself unable to agree with the proposition that:

[65] . . . any inconsistency between the reassessment and the waiver agreement allows a taxpayer to appeal any aspect of the reassessment as if no waiver had been given.  It does not make sense that any error in reassessing, however minor, could permit a taxpayer to repudiate the waiver entirely.

5. The Tax Court should decline to enforce the waiver agreement on the basis that it is unconscionable. 

This argument was not pressed strongly.  In any event, the judge could find no evidence to support it.

6. The taxpayer is appealing issues other than those dealt with in the waiver agreement. 

This argument was based on the sole shareholder’s belief about what was covered by the agreement (which was rather narrow) rather than the text of the agreement itself.  Justice Paris rejected reliance on subjective belief and concluded that a “reasonable person” standard must be applied:

[74]  When searching for the intentions of the parties, I believe that the search for intention in the case of a waiver is to be conducted in the same manner as for any contract on the basis of the parties’ manifested intention. That intention is determined from the perspective of the objective reasonable bystander. Fridman in the Law of Contract in Canada, refers to the classical formulation of this notion in Smith v. Hughes:

If whatever a man’s real intention may be, he so conducts himself that a reasonable man would believe that he was assenting to the terms proposed by the other party and that other party upon that belief enters into a contract with him, the man thus conducting himself would be equally bound as if he had intended to agree to the other party’s terms.

*  *  *

Underlying this decision is a clear public policy that negotiated settlements, as a general matter, ought to be upheld:

[45] . . . The desirability of upholding negotiated settlements was discussed by Bowie J. in 1390758 Ontario Corp v. The Queen: 

[35] I agree with Bowman C.J. and the authors Hogg, Magee and Li that there are sound policy reasons to uphold negotiated settlements of tax disputes freely arrived at between taxpayers and the Minister’s representatives. The addition of subsection 169(3) to the Act in 1994 is recognition by Parliament of that. It is not for the Courts to purport to review the propriety of such settlements. That task properly belongs to the Auditor General.

[36] The reality is that tax disputes are settled every day in this country. If they were not, and every difference had to be litigated to judgment, unmanageable backlogs would quickly accumulate and the system would break down.

[37] The Crown settles tort and contract claims brought by and against it on a regular basis. There is no reason why it should not settle tax disputes as well. Both sides of a dispute are entitled to know that if they invest the time and effort required to negotiate a settlement, then their agreement will bind both parties.

Although the taxpayer was unsuccessful, this decision is ultimately reassuring as the same principle applies to the government - if the CRA attempts to resile from a settlement agreement it too will be confronted by the same underlying public policy, namely, that negotiated settlements of tax disputes should be respected.

General Objectives of the Proposed Amendments

The general objectives of the proposed amendments are:

(1) to streamline the process of hearings and to codify the practice relating to litigation process conferences;

(2) to implement new rules and amend existing rules governing expert witnesses and the admissibility of their evidence in the Tax Court of Canada;

(3) to allow the Court to proceed with a hearing of one or more appeals, while other related appeals are stayed pending a decision on the lead cases heard by the Court;

(4) to encourage parties to settle their dispute early in the litigation process; and

(5) to make technical amendments.

Detailed Description of Proposed Amendments

(1) Streamlining the process of hearings and codifying the practice relating to litigation process conferences

A proposed definition of “litigation process conference” is added to section 2. That definition lists the hearings referred to in section 125 and the conferences referred to in subsection 126(2) and sections 126.1 and 126.2.

Amendments are proposed to subsection 123(4) to indicate that the Registrar or a designated person may fix the time and place for the hearing subject to any direction by the Court.

Proposed subsection 123(4.1) indicates that the Court may, on its own initiative, fix the time and place for the hearing.

Proposed subsection 123(6) indicates that, if the time and place for a hearing have been fixed after a joint application of the parties, the hearing should not be adjourned unless special circumstances justify the adjournment and it is in the interest of justice to adjourn it.

Amendments are required to be made to section 125 (Status Hearing) to provide that initial status hearings are ordered to take place approximately two months after the filing of the reply, and further status hearings can take place later in the appeal to ensure the appeal is ready for trial and to fix a trial date. Finally, proposed subsection 125(8) provides that where a party fails to comply with an order or direction made at a status hearing, or if a party fails to appear at a status hearing, the Court may allow or dismiss the appeal or make any other order that is appropriate.

Existing section 126 is replaced by proposed section 126, which is designed to allow the Chief Justice to assign a judge to manage an appeal that is complex, or slow moving, or for some other reason requires ongoing management by a judge. The judge takes responsibility for the progress of the appeal to ensure that the appeal proceeds to trial in a timely way while conserving judicial resources.

Proposed section 126.1 provides that a trial management conference can be held after the appeal hearing date has been set and is presided over by the judge assigned to preside at the hearing. The conference is to ensure that the hearing proceeds in an orderly and organized fashion.

Proposed section 126.2 permits the Court to direct that a conference be held for the purpose of exploring the possibility of settlement of any or all of the issues.

Amendments are required to section 127 to add references to sections 125 and 126, and to proposed section 126.1.

Amendments are required to section 128 to add references to matters related to a settlement or settlement discussions during a litigation process conference.

(2) Implementing new rules and amending existing rules governing expert witnesses and the admissibility of their evidence in the Tax Court of Canada

Subsection 145(1) is amended to replace the reference to “affidavit” by “expert report.”

Proposed subsection 145(2) provides that the expert’s report must set out the proposed evidence of the expert, the expert’s qualifications and be accompanied by a certificate signed by the expert acknowledging that the expert agrees to be bound by the Code of Conduct for Expert Witnesses that is added as a schedule to the Rules to ensure that expert witnesses understand their independent advisory role to the Court. Proposed subsection 145(3) indicates that if an expert fails to comply with the Code of Conduct, the Court may exclude some or all of the expert’s report.

Proposed subsection 145(4) requires a party to seek leave to the Court if they intend to call more than five expert witnesses at a hearing and proposed subsection 145(5) indicates what the Court has to consider in deciding to grant leave.

Proposed subsection 145(6) allows parties to name a joint expert witness.

Existing subsection 145(2) is renumbered subsection 145(7) and specifies the conditions that need to be met in order for evidence of an expert witness to be received at the hearing.

Existing subsection 145(4) is renumbered subsection 145(8) and indicates how evidence in chief of an expert witness is to be given at a hearing.

Proposed subsection 145(9) indicates what may be addressed during a litigation process conference, other than a settlement conference, in respect of expert witnesses.

Proposed subsections 145(10), (11), (12), (13) and (14) introduce new rules that deal with expert conferences.

Existing subsection 145(3) is renumbered subsection 145(15) and is amended to change the number of days, from 15 to 60, for a copy of rebuttal evidence to be served on all parties.

Proposed subsection 145(16) indicates when evidence of an expert witness can be led in surrebuttal of any evidence tendered under subsection (15).

Proposed subsections 145(17), (18), (19) and (20) allow the Court to require that some or all of the experts testify as a panel. Experts are only allowed to pose questions to each other with leave of the Court to ensure the orderly presentation of evidence. The rules governing cross-examination and re-examination will continue to apply to experts testifying concurrently.

(3) Allowing the Court to proceed with a hearing of one or more appeals, while other related appeals are stayed pending a decision on the lead cases heard by the Court

Proposed section 146.1 is intended to apply where there is more than one appeal which has common or related issues of fact or law. It allows the Court to proceed with the hearing of one of the appeals, the lead case, while other related appeals are stayed pending a decision on the lead case. The parties in a related appeal have to agree to be bound, in whole or in part, by the final decision on the lead case.

(4) Encouraging parties to settle their dispute early in the litigation process

The provisions of the Rules addressing offers to settle are designed to encourage parties to settle their dispute early in the litigation process. An early settlement has the added advantage of reducing the costs borne by the parties and conserving judicial resources.

Parties are entitled to make and accept offers of settlement at any time before there is a judgment and any written offer to settle will be considered by the Court in assessing costs under section 147. In addition to this general rule, there is a need to encourage parties to reach an early settlement, ideally before the beginning of the trial or hearing. This is the specific objective of adding subsections 147(3.1) to (3.8).

(5) Making technical amendments

To amend section 6 to provide that the Court may direct that any step in a proceeding may be conducted by teleconference, by videoconference or by a combination of teleconference and videoconference.

To amend section 52 by adding a new subsection to provide that a demand for particulars shall be in Form 52 and shall be filed and served in accordance with the Rules, and to add Form 52 to Schedule I.

To amend sections 53 and 58 to regroup all matters where the Court may strike out or expunge all or part of a pleading or other document under section 53, and all matters relating to the determination of questions of law, fact or mixed law and fact under section 58. As a consequence of these changes, sections 59, 60, 61 and 62 are repealed.

To add subsection 67(7) to provide for when proof of service of a motion must be filed.

To repeal subsection 95(3) as a result of the changes made to the expert witness rules.

To amend subsection 119(3) as a result of the changes made to the expert witness rules.

To amend paragraph 146(1)(d) to change the number of days for service from 10 to 5.

To add subsection 153(3) to provide that the taxing officer may direct that the taxation of a bill of costs be conducted by teleconference, videoconference or by combination of both.

To amend the reference to “issuing a judgment” by “rendering a judgment” in subsection 167(1).

To remove the reference to “and it shall be entered and filed there whereupon section 17.4 of the Act shall be complied with” in subsection 167(3).

*  *  *

The full text of the proposed amendments is here. Interested persons may make representations concerning the proposed Rules within 60 days after December 8, 2012. All such representations must cite the Canada Gazette, Part Ⅰ, and the December 8th date of publication of the notice, and be addressed to the Rules Committee, Tax Court of Canada, 200 Kent Street, Ottawa, Ontario K1A 0M1.

On November 19, 2012, the Tax Court released its decision in Berg v. The Queen (2012 TCC 406), which dealt with donative intent in the context of a donation scheme involving inflated charitable donation receipts. The Tax Court held that, although the taxpayer received documentation reflecting a valuation about nine times greater than the fair market value of the donations, the cash contributed by the taxpayer could effectively be segregated from the rest of the scheme and, thereby, constitute a “gift” for purposes of subparagraph 118.1 of the Income Tax Act.

Facts

In 2002 and 2003, Mr. Berg purchased 68 timeshare units, for which he paid $375,950 in cash and the remainder via low-interest financing. The taxpayer subsequently donated the units, and the recipient charity issued donation receipts for amounts approximately nine times higher than the fair market value of the units. The taxpayer claimed the inflated charitable donation tax credits. The CRA reassessed and disallowed the claimed charitable gifts of $2,420,000 for 2002, $1,786,000 for 2003 and $718,380 for 2004, including the portions paid by the taxpayer in cash for the units. 

The only issue before the Tax Court was whether the cash paid was a “gift” and therefore eligible for the charitable donation tax credit.

Analysis

The taxpayer argued that since he provided value for the units, and received no benefit from the charity (other than the credits themselves), the cash payments had to constitute a gift. The Crown argued that the inflated receipts conferred an additional benefit to the donor, thereby negating the donative intent of the taxpayer entirely. The Tax Court distinguished Marechaux v. The Queen in the Tax Court and Federal Court of Appeal on the basis that the Crown had conceded in this case:

[35] . . . that the Transaction Documents were pretenses and thereby not legally effective documents. Legally, no tangible or potential benefit to the Appellant, beyond the camouflage afforded by the Inflated Gift Receipts which were needed to enhance the purported gift value beyond the Cash Donation Amounts, can be ascribed to the Transaction Documents which, on admission by the Respondent, gave rise to no legal rights, obligations or benefits.

The Tax Court concluded as follows:

[48] . . . to the extent the Cash Donation Amount related to the Transferred Units, the Appellant was impoverished by, paid valuable consideration for, intended to give, and conveyed the Transferred Units which were, in turn, received by the Charity. Whatever opprobrium may be ascribed to the Donation Program, legally the Cash Donation Amount has met the legal test of a charitable gift. In the absence of some other benefit received beyond the Inflated Tax Receipts, no legal authority suggests donative intent as defined by the case law relevant to section 118.1 of the Act has been vitiated or nullified to the extent of the value of the Cash Donation Amount.

Conclusion

The Tax Court concluded that the taxpayer intended to donate to the charity, even if he was motivated by the possiblility of receiving an inflated tax receipt. This decision takes seriously the words of the Federal Court of Appeal in The Queen v. Friedberg in which it was held that a “gift is a voluntary transfer of property owned by the donor to a donee, in return for which no benefit or consideration flows to the donor.” In certain circumstances, including those found in this case, one may be able to effectively segregate the “gift” amount from the “non-gift” amount provided that the requisite degree of intent is found in connection with the former.  

It is not known whether the Crown will appeal the Tax Court’s decision to the Federal Court of Appeal.

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.

The Tax Court of Canada recently released its decision in Guindon, a case concerning the application of third-party penalties under section 163.2 of the Income Tax Act (the
“Act”). The Court found that the penalty imposed under section 163.2 of the Act is a
criminal penalty, not a civil one, and therefore subject to the same constitutional protections as other penal statutes enacted by the federal government.

Click here to read more.

In what is certain to be the first step in a very important precedent, the Tax Court of Canada held on October 2, 2012 that the advisor penalties created under section 163.2 of the Income Tax Act constitute criminal offences and entitle the taxpayer to all of the constitutional protections that entails, including a standard of proof beyond a reasonable doubt: Guindon v. The Queen, 2012 TCC 287.

The case involved a tax avoidance scheme that was deeply flawed from a technical perspective:

[1] The participants in a donation program (the “Program”) were to acquire timeshare units as beneficiaries of a trust for a fraction of their value and donate them to a charity in exchange for tax receipts for the actual value of the units. No donation ever took place as the timeshare units never existed and no trust was settled. The Minister of National Revenue (the “Minister”), on the basis that the Appellant made, participated in, assented to or acquiesced in the making of 135 tax receipts that she knew, or would reasonably be expected to have known, constituted false statements that could be used by the participants to claim an unwarranted tax credit under the Income Tax Act (the “Act”), assessed against the Appellant on August 1, 2008 penalties under section 163.2 of the Act in the amount of $546,747 in respect of false statements made in the context of that donation program. The Appellant appealed the assessment.

The appellant was a lawyer with no experience or expertise in tax law. Nevertheless she prepared an opinion that was used by the Program promoters to attract potential donors. The opinion was found to be badly flawed and purported to rely upon documentation which the appellant had never examined (and which, in fact, did not exist):

[105] The Appellant wrote and endorsed a legal opinion regarding the Program, an opinion which she knew would be part of a promotional package intended for potential participants in the Program. Her legal opinion clearly states that she reviewed the principal documents relating to the Program when these documents had in fact never been provided to her. She knew, therefore, that her legal opinion was flawed and misleading.

[106] The Appellant chose to rely on the Program’s Principals. They pressured her into providing them with an executed version of the legal opinion without providing her with the supporting documents on which to found her opinion. Yet her legal opinion does not reflect this reality. Rather, it indicates that the documents were reviewed.

[107] When the Appellant chose to involve the Charity in the Program and, later, to sign the tax receipts, she knew she could not rely on her legal opinion. She again decided to rely on the Principals. However, the Principals had relied on the Appellant to attest the legality of the Program. The Appellant knew her legal opinion could not be relied on and, for that reason, she could not be entitled to blindly rely on the Principals. In other words, the Appellant would have been entitled to rely on the Principals if a different professional had signed the legal opinion. She could not, however, rely on her own legal opinion which she knew to be incomplete.

[108] Her conduct is indicative either of complete disregard of the law and whether it was complied with or not or of wilful blindness. The Appellant should have refrained from involving the Charity and signing the tax receipts until she had either reviewed the documents herself or had another professional approve the Program’s activities. When the Appellant issued the tax receipts, she could have reasonably been expected to know that those receipts were tainted by an omission, namely, that no professional had ever verified the legal basis of the Program.

[109] The Appellant cannot agree to endorse a legal opinion and then justify her wrongful conduct by saying she did not have the necessary knowledge — either of tax law or of foreign law — to write that opinion.

[110] Moreover, the Appellant’s conduct after the tax receipts were signed negatively affects her credibility and reflects badly on her character. When the Appellant was informed, after the tax receipts had been issued, that the legal titles were not in order, she co-signed a letter informing the participants of the situation. At that point, the Appellant knew she could not rely on the Principals — the same individuals who had never provided her with the documents she was supposed to review and the same individuals she had trusted in signing the tax receipts. Yet when Ploughman sent out a letter, days before the end of the fiscal year, stating that all was in order and that the participants could submit their receipts, the Appellant blindly relied on him again, without asking any further questions.

Thus, it is reasonably clear that if the test under section 163.2 were a normal burden of “balance of probabilities” the advisor penalties against the appellant would have been sustained.

Justice Bédard, however, performed a very thorough and detailed analysis of section 163.2 to determine whether the penalties imposed amounted to criminal sanctions. At the end of that careful analysis he concluded that they did create criminal offences and allowed the appeal:

[69] The Respondent submits that it is not the penalty that would stigmatize the Appellant but rather her unlawful conduct and the professional sanctions that could result from it. What the Respondent fails to recognize is that this judgment, when rendered, will be public. That professional sanctions may be imposed subsequently does not alter the fact that there will be a public document setting out all the details of the Appellant’s conduct, whether that conduct was found to qualify as culpable conduct or not, and indicating the amount of the penalty that she is being assessed. This constitutes a form of stigma which one should not fail to consider.

[70] In conclusion, applying the rationale enunciated in Wigglesworth, section 163.2 of the Act should be considered as creating a criminal offence because it is so far-reaching and broad in scope that its intent is to promote public order and protect the public at large rather than to deter specific behaviour and ensure compliance with the regulatory scheme of the Act. Furthermore, the substantial penalty imposed on the third party — a penalty which can potentially be even greater than the fine imposed under the criminal provisions of section 239 of the Act, without the third party even benefiting from the protection of the Charter — qualifies as a true penal consequence.

This case will almost undoubtedly be appealed, quite possibly to the Supreme Court of Canada. Nevertheless, the rationale of the decision seems balanced and well-reasoned. If it is sustained on appeal it may very well sound the death knell for advisor penalties under section 163.2 since the burden of proof on the Crown, i.e., proof beyond a reasonable doubt, will normally be far too onerous to justify prosecuting such penalties.

Traditionally in a Tax Court appeal the costs awarded to a successful taxpayer have been no more than a small fraction of the out-of-pocket costs actually incurred in pursuing the appeal. The Court made very rare exceptions in the case of improper or vexatious conduct on the part of CRA. In recent years, however, the Tax Court has shown an increasing willingness to award substantial costs in cases where the taxpayer has been successful on important and novel issues. The recent decision of the Tax Court in Dickie v. The Queen (September 19, 2012) is an important example of how the law is evolving in this area.

In order to understand the implications of the cost award one must briefly examine the background of the underlying tax issue which was reported as Dickie v The Queen (July 10, 2012). The taxpayer was an aboriginal person living on a Reserve. He carried on a substantial business of cutting and slashing timber and brush to permit oil and gas exploration companies to carry out seismic testing. The administrative functions of the business were carried on within the Reserve but the physical activity of the business was carried on almost exclusively outside of the Reserve, generally within an 80 kilometre radius of the Reserve:

[8] While the Appellant clearly negotiated and received accepted contracts for work from the Reserve location, it is clear that 99% of the work was conducted off Reserve, within an 80-kilometre radius of the Reserve. In 2003, the Appellant had over 140 workers engaged for his Business and had revenue of approximately $3.4 million. The Appellant testified he hired mainly aboriginal workers, 16 in all from the Reserve, and others from Reserves in other parts of British Columbia, Alberta, Saskatchewan and even as far away as Newfoundland and Labrador. In all, the evidence is that approximately 105 of the 140 workers were aboriginal workers.

[9] The Appellant testified that the Business would bid on between 20 to 25 tenders a year and was usually successful 20% of the time, hence was awarded four to five contract bids a year. He also testified a small portion of the work of the Business was from small job requests but that the great majority of the Appellant’s Business revenue was from the larger bid contracts. The evidence is clear that all of the clients of the Business, generally oil and gas exploration or distribution companies, were not located or based on the Reserve and in fact most were based in Calgary, Alberta, the place of their office. The Appellant also testified that in 2003 the Business was a competitive one, evidenced also by the fact he was only successful on 20% of his bids.

The taxpayer claimed that his income was exempt for taxation by virtue of paragraph 81(1)(a) of the Income Tax Act:

81(1) There shall not be included in computing the income of a taxpayer for a taxation year,

(a) statutory exemptions [including Indians] – an amount that is declared to be exempt from income tax by any other enactment of Parliament, other than an amount received or receivable by an individual that is exempt by virtue of a provision contained in a tax convention or agreement with another country that has the force of law in Canada; . . .

Traditionally the courts construed this exemption somewhat narrowly placing significant emphasis on physical connection to the reserve and displaying a certain reluctance to apply the exemption to activities in the commercial mainstream.

Two recent decisions of the Supreme Court of Canada, Bastien Estate v. Canada, 2011 SCC 38, [2011] 2 S.C.R. 710 and Dubé v. Canada, 2011 SCC 39, [2011] 2 S.C.R. 764, substantially changed the law in this area. In a nutshell they held that the commercial mainstream test should no longer carry the degree of weight it had historically:

[21] Cromwell J. made it clear that the expression “Indian qua Indian” referred to by La Forest J. and Gonthier J. in Williams does not mean one can import into the purpose of the legislation “an effort to preserve the traditional way of life in Indian communities” or consider as a relevant factor “whether the investment income benefits the traditional Native way of life”. While Cromwell J. found that he did not read the judgments in Mitchell or Williams “as departing from a focus on the location of the property in question when applying the tax exemption”, he also found that neither decision mandated an approach that assessed what is in fact, to use the parlance of the Appellant here, the “Indianness” of the activity. In paragraph 27 of Bastien Estate, Cromwell J. stated:

[27] . . . A purposive interpretation goes too far if it substitutes for the inquiry into the location of the property mandated by the statute an assessment of what does or does not constitute an “Indian” way of life on a reserve. . . .

[22] And in paragraph 28 stated:

[28] . . ., a purposive interpretation of the exemption does not require that the evolution of that way of life should be impeded. Rather, the comments in both Mitchell and Williams in relation to the protection of property which Indians hold qua Indians should be read in relation to the need to establish a connection between the property and the reserve such that it may be said that the property is situated there for the purposes of the Indian Act. While the relationship between property and life on the reserve may in some cases be a factor tending to strengthen or weaken the connection between the property and the reserve, the availability of the exemption does not depend on whether the property is integral to the life of the reserve or to the preservation of the traditional Indian way of life. . .

[23] Likewise Cromwell J. cautioned against elevating considerations of whether the economic activity was in the “commercial mainstream” as a factor of determinative weight in determining the situs of investment income, which he felt was done in Recalma v. Canada, 98 DTC 6238 (F.C.A.) and other decisions of the lower courts, as “problematic” as he stated in paragraph 56 :

[56] . . . because it might be taken as setting up a false opposition between “commercial mainstream” activities and activities on a reserve. Linden J.A. in Folster was alive to this danger when he observed that the use of the term “commercial mainstream” might “… imply, incorrectly, that trade and commerce is somehow foreign to First Nations” (para. 14, note 27). He was also careful to observe in Recalma that the “commercial mainstream” consideration was not a separate test for the determination of the situs of investment property, but an “aid” to be taken into consideration in the analysis of the question (para. 9). Notwithstanding this wise counsel, the “commercial mainstream” consideration has sometimes become a determinative test. . . .

Justice Pizzitelli applied the new test enunciated by the Supreme Court and came to the conclusion that the taxpayer had demonstrated an entitlement to the exemption claimed and made the following direction as to costs:

[74] The appeal is allowed with costs to the Appellant; however, the parties are invited to file written submissions within 30 days as to costs if any of them feel a standard cost award should not stand.

In making his cost award roughly two months later Justice Pizzitelli was critical of CRA’s reliance upon the “commercial mainstream” argument in light of the Bastien and Dubé decisions:

[20] I do however also agree with the Appellant that having regard to the clear wording and intention of the Supreme Court of Canada’s decisions effectively reducing the importance of the commercial mainstream factor, if not obliterating it, that the Respondent could have shortened the proceeding by conceding this fact before trial. While the Respondent’s counsel acknowledged the reduction in weight to be given to the issue in argument at trial, she nonetheless maintained its assumptions in its pleadings regarding the commercial mainstream and argued forcefully that such factor would grant an advantage to aboriginal businesses over non-aboriginal businesses, an argument in my opinion clearly not consistent with the Supreme Court of Canada’s decisions on the issue. As I referred to in my decision, if the other factors are sufficient to establish the income was situate on a Reserve, then any such resulting advantage was acceptable. In my view, the Respondent could have significantly reduced the length of the hearing by conceding the argument before trial on receiving the Appellant’s counsel’s letter. In my view, this matter falls under the heading of Rule 147(h) the denial or the neglect or refusal of any party to admit anything that should have been admitted. In my opinion, the Respondent paid lip service to the Supreme Court of Canada’s decisions on the importance of the commercial mainstream argument yet proceeded to trial on the basis it was one of its strongest arguments.

In the result he awarded the taxpayer 60% of his out-of-pocket costs and 100% of his disbursements claimed:

[26] In my view, having regard to the clear victory of the Appellant in this matter, the sizeable amount of taxes in dispute including for other years for which this case served as a test case, the importance of the commercial mainstream issue in particular and the complexity of the issue in light of the Respondent’s position notwithstanding the Supreme Court of Canada’s decisions in Bastien Estate and Dubé and the amount of work generated for the Appellant as a result of the Respondent’s position on that issue and the importance it continued to give to the commercial mainstream factor as above discussed, which in my view should have been conceded before trial to shorten the trial and narrow the issues, there clearly exist special circumstances justified by the application of factors listed in Rule 147(3) to merit awarding the Appellant costs in excess of the Tariff.

[27] The Appellant asked for between 50 and 75% of solicitor and client costs plus disbursements, consistent with the range of traditional awards cited by author Mark Orkin in the Law of Costs, 2nd ed., Vol. 1 (Aurora: Canada Law Book, 2008) at 2-3 as quoted by Campbell J. in Re Zeller Estate above at paragraph 9. The Appellant’s costs on a solicitor and client basis claimed are $133,000 plus $10,000 in disbursements. In my opinion, the Appellant is deserving of 60% of such claim, amounting to $80,000 plus $10,000 in disbursements, for a total award of $90,000.

While the background of this case is somewhat uncommon, the issues it presents occur frequently in serious commercial tax litigation: important, novel issues involving a great deal of tax. When this is combined with a stubborn refusal on the part of CRA to acknowledge the obvious weaknesses of some of its arguments, we may begin to see more significant costs awards in the mold of the Dickie decision.

In my recent blog post on the Newmont Canada Corporation decision I examined the importance that the Federal Court of Appeal attached to credible evidence put forward by taxpayers in tax appeals. The recent decision of Justice Woods in the Tax Court in Bruno v. The Queen is a good illustration of a fair and balanced approach to weighing that evidence.

The taxpayer, Mrs. Bruno, had a business that specialized in supplying custom window coverings. During the 2007 and 2008 taxation years she employed two of her children in the business on a part-time basis and paid them (in the aggregate) $18,000 and $7,000, in each respective year, for their services.

Justice Woods summarized the evidence as follows:

[6] In the 2007 taxation year, Ms. Bruno reported income from the business in the amount of $11,944. In the 2008 taxation year, she reported a loss from the business in the amount of $16,963.

[7] Ms. Bruno’s two children were 15-16 and 13-14 in the years at issue and helped out in the business on weekends and holidays.

[8] According to Ms. Bruno’s evidence, the younger child did less skilled tasks such as cleaning and answering phones, and the older child did mainly clerical work. Both children also spent time learning sales.

[9] Ms. Bruno entered into evidence a summary of the hours worked and wages earned by the children. Wages were payable at the rate of between $10 and $12 per hour. The summary showed that the children generally worked store hours on both weekend days during 2007 and on one weekend day during 2008, as well as on holidays in both years. The reduction in the hours worked in 2008 was explained by Ms. Bruno on the basis that the business was not doing as well in that year.

[10] The wages were not paid by cheque. Instead, Ms. Bruno paid for some of the children’s personal expenditures which in aggregate are approximately equal to the wages shown on the summary. According to Ms. Bruno’s testimony, the expenditures were luxury items that the children chose to purchase out of the money that they had earned. A list of the expenditures with a brief description was kept by Ms. Bruno.

[11] Ms. Bruno stated that her accountant advised her that she could not take a deduction for expenditures on the children’s basic needs, but that she could take a deduction for luxury items. She said that she followed this advice and kept track of the expenses that would qualify.

[12] Ms. Bruno testified that she could veto any of the children’s purchases that were inappropriate but that she usually approved them.

The Crown’s position was short and to the point:

[15] At the outset, I would comment that the Crown did not argue that the wages were unreasonable based on the services performed and there was virtually no cross-examination of Ms. Bruno on this point. I will therefore accept that the amounts are reasonable.

[16] The Crown argued that the expenditures are not deductible because they are personal or living expenditures of Ms. Bruno and the children did not have sufficient discretion over the funds.

Justice Woods dismissed the Crown’s arguments that the children did not have sufficient discretion over the application of the funds:

[22] As for the Crown’s argument that the children did not have sufficient discretion over the funds, this argument is based on the decision of Beaubier J. in Bradley v The Queen, 2006 TCC 500, 2006 DTC 3535. Paragraph 9 of that decision reads:

[9] But in a related family, parent-child situation, payment must be made and deposited as it would be to a stranger. The payee must receive and control the alleged payment in his or her name and be able to use it for his or her benefit without any further control by the payer. That did not happen in this case.

[23] This comment suggests that the children must have complete discretion over the expenditures made. I would respectfully disagree with this and note that Bradley is not a binding precedent since it was an informal procedure case. I see nothing wrong with parents having a veto over expenditures made by their children.

Her conclusion on this point seems unimpeachable. There is little merit in the suggestion that a minor child must have entirely unfettered discretion as to what to do with his or her earnings in order for those amounts to constitute the child’s income. Would it be any less the child’s income if the parents could veto a decision by the minor to purchase a pit bull or pay for hang-glider lessons?

On the broader issue whether wages paid to children were deductible, Justice Woods relied upon the Symes decision of the Supreme Court of Canada:

[19] In considering the interplay between s. 18(1)(a) and (h), the majority decision in Symes concluded that the prohibition for personal expenditures in s. 18(1)(h) does not apply to an expenditure that was laid out for the purpose of earning income. Justice Iacobucci stated, at page 6014:

Upon reflection, therefore, no test has been proposed which improves upon or which substantially modifies a test derived directly from the language of s. 18(1)(a). The analytical trail leads back to its source, and I simply ask the following: did the appellant incur child care expenses for the purpose of gaining or producing income from a business?

[20] Accordingly, if a taxpayer incurs an expense for the purpose of gaining or producing income from a business, the deduction will not be prohibited pursuant to s. 18(1)(h) on the basis that it also has a personal benefit to the taxpayer.

[21] Applying this principle to the facts in this case, if the children are owed wages in reasonable amount, a deduction may be claimed if the wages are paid in the form of purchasing luxury personal items chosen by the children.

Justice Woods then turned to what was undoubtedly the most difficult aspect of this case: weighing and assessing the taxpayer’s evidence.

[24] Turning to the facts of this case, the difficulty that I have with Ms. Bruno’s argument is that the evidence about the expenditures was not sufficiently detailed for me to be satisfied, even on a prima facie basis, that all the expenditures were made for the children’s benefit, let alone that they were for luxury items.

[25] The evidence concerning the nature of the expenditures consisted mainly of Ms. Bruno’s oral testimony and the list that she prepared. As for the oral testimony, it is self‑serving and not sufficiently detailed for me to be satisfied on most of the expenditures. As for the accounting records, a great many of the descriptions of the expenditures were simply too general to be of great assistance.

[26] Based on the evidence as a whole, I am satisfied that some of the expenditures are luxury items for the children’s benefit. However, the evidence is not detailed enough for me to determine which items qualify. It is appropriate in these circumstances, where the appeal is governed by the informal procedure, for the Court to make a rough estimate. On that basis, I propose to allow a deduction for 50 percent of the amounts claimed.

On the one hand she accepted that the services were provided; that the children’s labour actually constituted a tangible benefit to the business. On the other hand the taxpayer had not put forward a sufficiently strong case to persuade Justice Woods that there was not an element of personal benefit to the parents. As a result she split the difference and allowed 50% of the salary expenses claimed.

While the Bruno decision is an informal procedure case and involved relatively small amounts, in my view it clearly illustrates the difficulty a trial judge has in assessing the evidence of a credible witness dealing with difficult or imprecise facts. It further demonstrates the importance of careful preparation of witnesses and the documentary evidence that must be introduced. Finally, it shows once more that counsel must have a finely-tuned ear to anticipate and deal with the types of issues that will likely concern the trial judge.

In Hine v. The Queen (2012 TCC 295), a decision released last week, the Tax Court of Canada considered whether a taxpayer was “grossly negligent” in relying on his accountant (who happened to be his wife) to prepare his tax return, and whether the taxpayer’s written offer to settle (asking the Crown to concede entirely) should be considered when making a cost award.

The decision in Hine is helpful in determining (a) whether the taxpayer was grossly negligent in relying entirely on his tax preparer, and (b) whether a settlement offer may be ignored by the Tax Court in awarding costs.

Gross Negligence – 163(2)

The taxpayer was a general contractor who was in the business of “flipping” homes. In 2006, he sold a renovated house for $319,000. The taxpayer reported a loss of $131,653 for the year. In the course of an audit that commenced in 2008, the CRA discovered that the taxpayer had failed to report $157,965 of business income on the sale of the house. The CRA reassessed to include the additional income and imposed a gross negligence penalty under subsection 163(2) of the Income Tax Act. Only the gross negligence penalty was at issue in the appeal.

Generally, under subsection 163(2), the CRA may impose a penalty equal to the greater of $100 and 50% of the avoided tax where the taxpayer knowingly, or under circumstances amounting to gross negligence, made a false statement or omission in a return.

The courts have been consistent in holding that a high degree of negligence or intentional acting is required in order for the gross negligence penalty to apply (see, for example, Udell v. M.N.R., 70 DTC 6019 (Ex. Ct.)). However, there has been less consistency in the application of the penalty where the taxpayer relied on the work of his/her tax preparer. Generally, in such cases, there must be gross negligence on the part of the tax preparer, and there must be some element of privity or wilful blindness on the part of the taxpayer such that he/she acquiesced in the making of the false statement or should have taken further steps to confirm the accuracy of the return.

In Hine, the taxpayer handed over responsibility for the bookkeeping and tax returns to his wife, who had a background in financial accounting but was not a professional accountant. The taxpayer relied entirely on his wife to keep proper records and prepare his returns. The wife’s error resulted in the underreported income, and neither the taxpayer nor his wife detected the error before filing the return.

In argument, the taxpayer relied on a line of cases establishing that reliance on professional advisors does not necessarily lead to a finding of gross negligence (see, for example, Findlay v. The Queen (2000 DTC 6345 (Fed. C.A.)), Gallery v. The Queen (2008 TCC 583) and Down v. M.N.R. (93 DTC 591) (T.C.C.)). The Crown relied on a line of cases that states that a taxpayer cannnot escape his or her own liability under subsection 163(2) by simply handing over all tax affairs to a professional advisor (see, for example, Panini v. The Queen (2006 FCA 224), Hougassian v. The Queen (2007 TCC 293) and Brygman v. M.N.R. (79 DTC 858) (Tax R.B.)).

The Tax Court found that the taxpayer and his wife intended to be diligent and accurate in reporting the taxpayer’s income, and an honest confusion led to the error.

Finally, the Tax Court held that the determination of the issue of whether the taxpayer and his advisor were grossly negligent was unaffected by the their spousal relationship. On the facts of the case, the taxpayer’s “blind faith in his wife” was not unreasonable. The Tax Court allowed the taxpayer’s appeal.

Costs

After the court’s decision, the taxpayer sought costs above the usual tariff amounts on the basis that a settlement offer had been made before the hearing. The taxpayer argued that the offer should be considered under paragraph 147(3)(d) of the Tax Court of Canada Rules (General Procedure) and enhanced costs awarded.

In his written offer, the taxpayer had set out certain submissions he intended to make at the hearing and argued that the gross negligence penalty was unsupportable. The taxpayer offered to settle the matter, without costs, if the Crown reassessed accordingly (i.e., conceding the penalty in its entirety). The taxpayer stated that if the Crown did not accept the settlement offer the taxpayer would seek solicitor and client costs if successful at trial. The Crown rejected the offer.

The Tax Court dismissed the taxpayer’s request for enhanced costs and stated that “… An ‘offer’ that the other party to the litigation withdraw in order to avoid a threat of enhanced costs cannot, in this circumstances, be considered to be an ‘offer of settlement’.” Further, the court stated that, “To have ‘settled’ the case as offered by the Appellant would have been to abdicate the responsibilities imposed on the Department of Justice.” (See also CIBC World Markets Inc. v. The Queen (2012 FCA 3) on the difficulties of making a settlement offer where there is a “yes-no” question at issue in the appeal.)

Accordingly, parties to a tax dispute should ensure that their offers are “settlement” offers and not “withdrawal” offers and that the offer is the type of offer that can indeed be accepted by the other party. Otherwise a court may decline to consider the offer when assessing costs.

In what circumstances can a party obtain a large lump-sum cost award after a favourable Tax Court decision?

That was the question considered by the Tax Court in Velcro Canada Inc. v. The Queen (2012 TCC 273), in which the Tax Court awarded the successful taxpayer a lump sum cost award of $60,000 plus disbursements. The Court’s reasoning has provided some helpful clarification on the manner in which the Court will determine the nature and amount of a cost award.

In the main appeal (Velcro Canada Inc. v. The Queen, 2012 TCC 57), the Appellant taxpayer was successful in establishing that a Dutch holding company was the “beneficial owner” of royalties paid by a related Canadian company. (See our previous commentary on the decision by FMC’s Matt Peters here.)

At the costs hearing, the Appellant argued that the Tax Court should award enhanced costs because the Appellant had been entirely successful in the appeal, the amount in issue was in excess of $9 million, the issues raised were of national and international importance, and the novelty of the issues required additional time and resources in preparing for and conducting the appeal.

The Respondent’s view was that costs should be assessed in accordance with Tariff B of Schedule II of the Tax Court of Canada Rules (General Procedure). The Respondent argued that the main issue had previously been considered in the ground-breaking case of Prévost Car Inc. v. The Queen (2008 TCC 231; aff’d 2009 FCA 57), and that the Appellant had not adduced evidence of the work and effort put into the appeal. Further, no exceptional circumstances existed that would justify the Court exercising its discretion to award costs beyond the Tariff.

The Tax Court considered the factors discussed in section 147 of the General Procedure Rules and Tariff B of Schedule II thereto, and concluded that no exceptional circumstances were required to justify a deviation from the Tariff. In fact, the discretion of the Tax Court is quite wide – the Tariff may be relied on, but only if the Court chooses to do so. The Court stated:

[16] Under the Rules, the Tax Court of Canada does not even have to make any reference to Schedule II, Tariff B in awarding costs. The Court may fix all or part of the costs, with or without reference to Schedule II of Tariff B and it can award a lump sum in lieu of or in addition to taxed costs. The Rules do not state or even suggest that the Court follow or make reference to the Tariff. …

[17] It is my view that in every case the Judge should consider costs in light of the factors in Rule 147(3) and only after he or she considers those factors on a principled basis should the Court look to Tariff B of Schedule II if the Court chooses to do so. … [emphasis in original]

The Court went on to consider the result in the proceeding (taxpayer was entirely successful), the amount in issue (more than $9 million), the importance of the issues (very important domestically and internationally), any settlement offer in writing (there wasn’t one), the volume of work (considerable effort required), the complexity of the issues (relatively straight-forward but in a complex factual matrix), and the conduct of the parties (very well pleaded and impressive presentations at the hearing). The Court awarded $60,000 plus disbursements to the Appellant.

The Court’s decision is significant because it signals an evolution in the approach to cost awards from the currently accepted practice.

As most tax litigators know, a general practice developed whereby large lump-sum cost awards were sought only in exceptional circumstances (i.e., where one party had engaged in misconduct or unnecessary procedural wrangling). The decision of Associate Chief Justice Rossiter appears to open the door to the possibility of seeking large lump-sum cost awards in any proceeding because, according to the Court, the Judge should look first to section 147 of the Rules and may, but not necessarily, look to the Tariff.

It seems that this approach accords with the Tax Court’s recent focus, and emphasis, on the importance of settlements. The parties to a tax appeal should not lightly dismiss the Court’s reasoning in Velcro Canada when considering whether to settle a matter before going to trial.

On April 26, 2012, Justice J.E. Hershfield of the Tax Court of Canada heard arguments in Nuclear Waste Management Organization v. The Queen in respect of a reassessment under the Canada Pension Plan (the “Plan”).  In written reasons released on June 18, 2012, Justice Hershfield found in favour of the Crown and upheld the assessment under the Plan. 

The facts of the matter were not in dispute.  The issue was entirely a matter of statutory interpretation, that being whether individuals appointed to the Advisory Board of the taxpayer were appointed to an “office” within the meaning of subsection 2(1) of the Plan.  If so, the members of the Advisory Council were engaged in pensionable employment as per section 6 of the Plan.  The Advisory Council was appointed in accordance with the Nuclear Fuel Waste Act and was composed of representatives of various interested parties.  The Advisory Council had no decision-making power over the taxpayer and could only make non-binding recommendations. 

The taxpayer took the position that because the Advisory Board’s remuneration was paid in part on a per diem basis, and because the number of meetings was not fixed from year to year, the remuneration was neither fixed nor ascertainable, such that it was not contemplated in the definition of “office” contained in the Plan.  Unfortunately for the taxpayer, two recent decisions (M.N.R. v. The Queen in Right of Ontario and M.N.R. v. Real Estate Council of Alberta) unequivocally confirm that compensation that is paid on a per diem basis is “ascertainable”.

The taxpayer’s second ground for appeal was that the definition of “office” should not be read to include volunteers, because it is not contained in the enumerated positions listed.  The definition contained in the Plan reads as follows:

“office” means the position of an individual entitling him to a fixed or ascertainable stipend or remuneration and includes a judicial office, the office of a minister of the Crown, the office of a lieutenant governor, the office of a member of the Senate or House of Commons, a member of a legislative assembly or a member of a legislative or executive council and any other office the incumbent of which is elected by popular vote or is elected or appointed in a representative capacity, and also includes the position of a corporation director, and “officer” means a person holding such an office;

Justice Hershfield noted that the definition contains an exhaustive definition (“means”) and a non-exhaustive definition (“includes”).  After observing that the exhaustive definition clearly captured the members of the Advisory Board, he turned his attention to the effect of the second half of the definition.  Presuming that the definition is not redundant, it could be interpreted to carve out certain members of the public service, who are then brought back into the definition (or not) by specific enumeration.  As the volunteers of the Advisory Board are not enumerated, the taxpayer argued that they were not included in the definition.

This reasoning was not persuasive to Justice Hershfield, who preferred to interpret the enumerated examples as being added for greater certainty to include those individuals who attain their position of office in a unique or unusual fashion.  The additional fact that all of the enumerated offices are examples of positions with real authority (and not merely advisory) was not sufficient to convince Justice Hershfield that an advisory role would be excluded. 

It is too early to tell whether this decision will be appealed.  It should be noted that the definition of “office” contained in section 248 of the Income Tax Act is identical to the definition contained in the Plan.  The same definition is also incorporated in paragraph 5(4)(g) of the Employment Insurance Act and its regulations.  It seems safe to assume that Justice Hershfield’s analysis would be equally applicable to a question under either of those statutes.

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.

On March 21, 2012 the Tax Court of Canada issued judgment in the decision of McClarty Family Trust et al v. The Queen. The Minister of National Revenue (the “Minister”) had applied the general anti-avoidance rule (the “GAAR”) in section 245 of the Income Tax Act (the “Act”) to re-characterize capital gains reported by the McClarty Family Trust (“MFT”) as taxable dividends. However, the Court agreed with the appellants’ submissions that the transactions in issue were undertaken primarily for the purpose of placing Darrell McClarty, the father of the minor beneficiaries of the MFT, beyond the reach of creditors and allowed the appeal.

The Minster’s argument was that pursuant to a series of transactions, Darrell McClarty was able to split business income with his minor children in a manner that avoided the tax on split income in section 120.4 of the Act (as it existed in 2003 and 2004).

Darrell McClarty was the owner of all of the issued and outstanding Class A voting shares of McClarty Professional Services Inc. (MPSI). The MFT owned all of the issued and outstanding Class B, non-voting common shares. MPSI, in turn, owned 31% of Projectline Solutions Inc., which earned business income from the provisions of geotechnical engineering services.

In 2003 and 2004, the MFT received stock dividends consisting of Class E common shares of MPSI. The Class E shares had low paid-up capital and a high redemption value. After the Class E shares were received by the MFT, the MFT sold them to Darrell McClarty for fair market value, realizing capital gains. The capital gains were then distributed to the minor beneficiaries of the MFT, and thereby not subject to tax under section 120.4 of the Act.

Through a series of loans between Darrell McClarty, MPSI and the MFT, Mr. McClarty ended up owing $104,400.37 in outstanding promissory notes to the MFT and the MFT had outstanding promissory notes in the amount of $96,000 owned to its minor beneficiaries. The Minister argued that the creditor protection objectives were essentially ineffective and that the circular flow of loans disguised the true intention of the plan, which was to distribute funds to minor beneficiaries in a manner that would not subject them to the tax on split income in section 120.4.

However, the Court accepted Mr. McClarty’s evidence that he was motivated to protect assets from his former employer, who was a potential judgment creditor in relation to allegations of improper use of software belonging to the former employer. The Court also agreed that because of the liabilities of Mr. McClarty and the MFT noted above, the creditor protection objectives were achieved.

It was also argued that the protection from creditors would have been achieved simply by paying dividends to the beneficiaries of the MFT and therefore the declarations of stock dividends amounted to avoidance transactions. However, the Court accepted the Appellants’ argument that the transfer of wealth from MPSI was undertaken to provide protection from creditors without attracting significant tax costs. The transactions were not avoidance transactions because it was acceptable to undertake creditor proofing transactions in a manner that attracted the least possible tax. Furthermore, the transaction would never have occurred in the absence of the need to protect MPSI’s assets.

The Court therefore concluded that because there were no avoidance transactions under subsection 245(3) of the Act, there was no need to continue the analysis to determine if there was abusive tax avoidance. However it did note that to the extent that there was a gap in the legislation, which allowed for the distribution of capital gains to minor beneficiaries of a trust in a manner that was not taxable under section 120.4 of the Act, it was inappropriate for the Minister to use the GAAR to fill in the gaps.

In Morguard Corporation v. The Queen, 2012 TCC 55, Justice Boyle of the Tax Court of Canada considered whether a “break fee” received by a predecessor of the Appellant (for the purposes of this discussion, the “Appellant”) in respect of its unsuccessful attempted acquisition of a public corporation, was received on account of income or capital (there was also a procedural issue that will not be discussed in this post).  Based on the approach set out in Ikea Ltd. v. Canada, [1988] 1 SCR 196, 98 DTC 6092, affirming 96 DTC 6526 (FCA) and 94 DTC 1112 (TCC), Justice Boyle concluded that, on the facts, a break fee such as the one received by the Appellant was taxable on account of income because the negotiation and inclusion of break fees in the Appellant’s acquisition agreements was an integral part of its commercial business operations and activities. 

The relevant facts in this case are quite simple. In early 1997, the Appellant commenced implementation of its business strategy of assembling direct or indirect ownership of, or controlling positions in, real estate companies.  As a result of this business strategy, the Appellant acquired large/controlling interests in a number of real estate companies. 

In 1998, the Appellant acquired 19.2% of Acanthus Real Estate Corporation (“Acanthus”).  In June 2000, the Appellant made a hostile take-over bid for all of the remaining shares in Acanthus at a purchase price of $8.00, thereby increasing its position to 19.9%.  Following negotiations between Acanthus and the Appellant, the parties entered into a pre-acquisition agreement in order to give support and deal protection to the Appellant and the bid.  Pursuant to this pre-acquisition agreement, it was agreed that the Appellant would acquire all the outstanding shares of Acanthus at a purchase price of $8.25 per share and that Acanthus would, inter alia, pay a break fee of $4.7 million to the Appellant if a better bid was received and accepted by Acanthus.

On June 29, 2000, Acanthus received an unsolicited bid from a third-party (the “Third-Party”) for all of the outstanding shares of Acanthus at a purchase price of $8.75.  Attempting to thwart the Third-Party bid, the Appellant increased its bid to $9.00 per share on July 2, 2000.  At that time, the Appellant and Acanthus entered into an amending agreement (the “Amending Agreement”) to the original pre-acquisition agreement, pursuant to which a superior offer from a third-party would need to be for at least $9.30 per share and the break fee was increased to $7.7 million. 

Ultimately, Acanthus accepted an offer from the Third-Party for $9.40 and the Appellant chose not to match the offer.  Consequently, the Amending Agreement was terminated and Acanthus paid the Appellant the $7.7 million break fee.  In addition to the $7.7 million break fee (the “Break Fee”), the Appellant realised a gain of $4.8 million on the sale of its shares of Acanthus.

The Appellant argued that the Break Fee was a capital receipt and therefore should not be taxable because it was not received in respect of a disposition of property (i.e. no property was actually disposed of).  Critical to the Appellant’s argument was, the fact that (a) the Break Fee was received in relation to the acquisition of shares of Acanthus, which was a capital investment, and (b) the receipt of the Break Fee was the only time the Appellant had ever received a break fee in attempting to implement its real estate company acquisition strategy. 

After dismissing the Appellant’s “windfall” argument, Justice Boyle noted that Ikea is the leading modern case on the characterization of extraordinary or unusual receipts in the business context.  In that case, the taxpayer sought to assemble long-term leaseholds from which to operate its business.  In doing so, the taxpayer received a “tenant inducement payment” which it treated on capital account because the payment was received in respect of a long-term lease, which is capital in nature.  All levels of court found that the receipt was on income account because the leaseholds were necessary to the business of the taxpayer and they were a necessary incident to the conduct of the taxpayer’s business.  Consequently, the capital purpose (assembling long-term leaseholds) was not the relevant link to be considered. 

Citing the reasons for Judgment in the Tax Court of Canada in Ikea, Justice Boyle noted, at paragraph 43, that Justice Bowman was correct in finding “that the payment was clearly received and inextricably linked to [the taxpayer’s] ordinary business operations, and further that no question of linkage to a capital purpose could even be seriously entertained.”  In this case, Justice Boyle found that break fees were expected incidents of the Appellant’s business strategy of entering into acquisition agreements with real estate corporations, regardless of how unusual the receipt of such a payment may be and, therefore, the Break Fee was an amount received in the course of the Appellant’s business and commercial activities.  Consequently, the receipt of the Break Fee by the Appellant was on account of income.

The Tax Court has once again considered the meaning of the phrase “beneficial owner” for purposes of the tax treaty between Canada and the Netherlands (the “Treaty”).  It has also once again ruled in favour of the taxpayer in determining that a Dutch holding company was the “beneficial owner” of amounts received from a related Canadian company.

On February 24, 2012, the Tax Court of Canada released its eagerly-anticipated decision in Velcro Canada Inc. v. Her Majesty the Queen, which addresses the applicable Canadian withholding tax rate in respect of cross-border royalty payments within a multinational corporate group.  The decision comes almost four years after the Tax Court of Canada released its landmark decision in Prévost Car Inc. v. The Queen, which dealt with the identical treaty interpretational issue in the context of cross-border dividend payments.  The decision of the Tax Court was affirmed by the Federal Court of Appeal.

Both the Prévost Car Inc. and Velcro decisions are relevant to any multinational enterprise using a foreign holding company as an investment/financing vehicle and provide considerable comfort concerning the tax effectiveness of such structures.

The issue in Velcro was whether a Dutch holding company was the “beneficial owner” of royalties paid by a related Canadian company, and therefore entitled to a reduced rate of Canadian withholding tax under the Treaty in respect of the royalties.  Pursuant to the “beneficial owner test” described in Prévost Car Inc., this required that the Tax Court consider the following issues:

• Did the Dutch holding company enjoy possession, use, risk and control of the amounts it received from the Canadian corporation?
• Did the Dutch holding company act as a “conduit”, an agent or a nominee in respect of the amounts it received from the Canadian corporation?

The CRA’s position was that Dutchco was not the beneficial owner of the royalties generally because Dutchco was contractually required to remit a specific percentage of all amounts received from the Canadian corporation to its parent company located in the Netherlands-Antilles (which does not have a comprehensive tax treaty with Canada).  If the Canadian company had paid royalties directly to the Netherlands-Antilles company the royalty payments would have been subject to a 25% Canadian withholding tax.  In the CRA’s view, Dutchco was merely a collection agent for the Netherlands-Antilles company.

The Court rejected the CRA’s arguments and concluded that Dutcho was indeed the beneficial owner of the royalties.  The basis for the Court’s conclusion was that, even though Dutchco may have been contractually required to pay money onward to the Netherlands-Antilles company, it retained some discretion as to the use of the royalties while in its possession. Dutchco therefore possessed sufficient indicia of beneficial ownership while it held the royalties and could not be considered a conduit based on the “beneficial ownership test” outlined in Prévost Car Inc., which requires a lack of all discretion.

It is unclear at this time whether the CRA will appeal the Tax Court’s decision in Velcro to the Federal Court of Appeal. The tax community will continue to watch the progress of this case (if any) with great interest.

Please open the attached PDF for further information about the Velcro case.

Please visit the FMC website for prior coverage of Prévost Car Inc.

The most recent Canadian transfer pricing trial concluded on February 3, 2012 after four days of argument in the Tax Court of Canada in Toronto. This marked the conclusion of a trial that commenced on October 17, 2011. At issue before Justice Patrick Boyle is whether the agreed-upon discount rate for factoring accounts receivable differed from the discount rate to which the parties would have agreed had they been dealing with one another at arm’s length.

The agreed-upon discount rate was 2.2% while the Minister of National Revenue assumed 1.0127% as the arm’s length rate for factoring the accounts receivable at issue.

Counsel for McKesson Canada Corporation began his submissions by arguing that the reassessment should be vacated as McKesson Canada had met its burden of demonstrating to the Court, on a balance of probabilities, that the agreed-upon discount rate was consistent with the discount rate to which the parties would have agreed had they been dealing with one another at arm’s length. Counsel argued that the absolute lowest discount rate the Court could possibly find, based on all the expert evidence, is not be less than 1.7863% as reflected in the opinion of one of the Crown’s experts. Counsel emphasized that the evidence of the Crown’s experts should be given little or no weight as, among other things, they overlooked cost of capital, prompt payment discount and servicing fees. Furthermore, counsel submitted that the Part XIII assessment should be vacated as it was issued after the 5-year limitation period in Article 9(3) of the Canada-Luxembourg Income Tax Convention (1999) (the “Treaty”).

Counsel for McKesson Canada referred to the OECD guidelines which suggest that restructuring business transactions would be an unusually arbitrary exercise. He emphasized that paragraph 247(2)(a) of the Income Tax Act cannot be used to re-write the transaction or to change what has already happened.

Justice Patrick Boyle sought guidance from counsel on whether paragraph 247(2)(a) could be used to revise the terms or conditions of the transaction.

Crown counsel criticized the methodology used by an experts called by McKesson Canada on the basis that he had never used that methodology to price any other receivables and there was no indication that that methodology was actually followed in the market. Counsel also questioned certain assumptions made by experts called by McKesson Canada (e.g. the Crown argued that capitalization should be assessed based on the capitalization of the entire corporate group, not just the immediate parent, which would result in a significantly lower arm’s length discount rate).

Crown counsel also argued that the “terms and conditions” referred to in paragraph 247(2)(a) extend beyond price and, based on the OECD guidelines, that structural adjustments are permissible as part of the “realistically available option” standard. Counsel submitted that the “realistically available option” standard allows for several significant adjustments to the discount rate.

Justice Boyle sought guidance from Crown counsel on the extent to which structural changes could be made within the scope of paragraph 247(2)(a).

With respect to the Part XIII assessment, Crown counsel contended that the limitation period in Article 9(3) of the Treaty only applies to corresponding adjustments by the other contracting state and, therefore, the Part XIII assessment was timely issued.

In reply, counsel for McKesson Canada urged the Court to look to the words of paragraph 247(2)(a) and emphasized that the discount rates offered by the experts called by McKesson Canada took into account considerations such as the cost of capital and the servicing fee where the discount rates offered by the Crown’s experts did not.

Judgment was reserved.

Taxpayers that have implemented cross-border tower financing structures and that have claimed a Canadian tax deduction for any U.S. taxes paid should revisit their structures carefully in light of the Tax Court of Canada’s recent decision in FLSMIDTH Ltd. v. The Queen (2012 TCC 3), which is the Court’s first decision concerning tower structures.

For a more detailed review of this case, please click here.

The primary tax benefit of the typical tower structure is an interest deduction in both Canada and U.S. in respect of the same borrowing.  However, in certain tower structures, a spread is earned by a U.S. entity based on the amount of interest that is received by that entity from lower-tier entities in the structure and the amount of interest that is paid by the entity on external bank financing.  This spread is typically subject to U.S. federal income tax.

In FLSMIDTH Ltd. v. The Queen, the viability of the double interest deductions was not at issue; rather, the issue was whether an additional deduction under subsection 20(12) of the Income Tax Act (Canada) (the “Act”) was available under the Act with respect to the U.S. income tax that was paid on the spread.

Generally, the taxpayer would be entitled to the deduction under subsection 20(12) of the Act for the U.S. tax paid if two conditions were met:

1. the tax must have been paid in respect of a source of income under the Act; and

2. the U.S. tax must not reasonably be regarded as having been paid in respect of income from the share of a capital stock of a foreign affiliate of the taxpayer.

The Tax Court agreed that the U.S. tax was paid in respect of a source of income for purposes of the Act, even though that specific source of income (i.e., income that was characterized as interest for U.S. tax purposes) was not itself subject to tax under the Act; however, the Tax Court denied the deduction on the basis that the tax was in respect of income from the share of a foreign affiliate of the taxpayer.  Central to the Court’s decision was the broad interpretation that is to be given to the term “in respect of” for purposes of the Act.

Taxpayers that have implemented tower structures and that have claimed a subsection 20(12) deduction on any U.S. tax paid should reconsider their structures and contact a tax advisor to discuss the potential implications of this case in their particular circumstances.

At this time it is unclear whether the taxpayer will appeal this decision to the Federal Court of Appeal.

On December 19, 2011, the Tax Court partially granted an application by Canadian Imperial Bank of Commerce (“CIBC”) (2011 TCC 568). The motion concerned whether the Crown’s Reply should be struck out, either wholly or in part (there were actually four separate Replies, but all are substantially similar). Associate Chief Justice Rossiter did not strike out the entire Crown pleading, but ordered 98 paragraphs struck out and 92 paragraphs amended from the main Reply (with the same amendments to be made to the other three Replies). The main Reply was 94 pages long with 70 pages of assumptions.

The Tax Court appeals involve the deductibility of amounts paid by CIBC to settle litigation arising from the failure of Enron in 2001. CIBC was named (along with a number of other parties) as a defendant in a pair of law suits filed after Enron went bankrupt. CIBC settled the claims against it in consideration for a payment of $2.65 billion in 2005 and deducted those amounts, along with related interest and legal expenses in computing income for its 2005 and 2006 taxation years.

The Minister of National Revenue denied the deduction of the settlement amounts. CIBC appealed to the Tax Court of Canada. The Crown filed a Reply, and CIBC filed a motion to have the Reply struck out in its entirety. The contentious point is whether the “egregious or repulsive” principle can be used to determine whether expenses are deductible. The concept was referred to at paragraph 69 of the reasons for judgment in 65302 British Columbia Ltd. v. Canada where a majority of the Supreme Court of Canada (per Iacobucci J.) made the following observation:

It is conceivable that a breach could be so egregious or repulsive that the fine subsequently imposed could not be justified as being incurred for the purpose of producing income. However, such a situation would likely be rare and requires no further consideration in the context of this case, especially given that Parliament itself may choose to delineate such fines and penalties, as it has with fines imposed by the Income Tax Act.

On this motion, the Crown argued that it should be open to it to establish that the “egregious or repulsive” principle could also apply in respect of amounts paid in order to settle litigation. CIBC contended that this concept has never been held to apply to settlement amounts and that, as a result, the Reply was fatally deficient.

Associate Chief Justice Rossiter first concluded that part of a pleading should only be struck where it is “certain to fail because it contains a radical defect.” Here, the Crown was trying to use the “egregious or repulsive” principle to justify denying the deduction of amounts paid to settle a law suit rather than amounts laid out to pay fines. The Court acknowledged that the “egregious or repulsive” principle had been developed by the courts in the context of fines, but noted that it could apply to settlement payments, and so the Respondent’s pleadings did have a chance of success. He refused to strike the Crown’s entire pleading as a result.

However, Associate Chief Justice Rossiter found that in the Reply the Crown pleaded evidence, conclusions of law or mixed fact and law, immaterial facts or advanced prejudicial or scandalous claims or claims that were an abuse of process of the Court. In the result, the Court held that portions of the Reply were improper and had to be removed. The Crown was given 60 days to file a less argumentative Amended Reply with the offending portions deleted.

On December 5, 2011, the Federal Court of Appeal released its decision in John Fluevog v. The Queen (2011 FCA 338).  In a unanimous judgment, Justices Nadon, Sharlow, and Mainville allowed the Crown’s appeal, reversing an interlocutory decision of Justice Margeson of the Tax Court of Canada (2010 TCC 617).  In that decision, the Tax Court had permitted the taxpayer, Mr. Fluevog, to amend his Notice of Appeal to add a claim of discrimination under section 15 of the Canadian Charter of Rights and Freedoms.

Mr. Fluevog made payments to Swim Canada, an organization that is a “registered Canadian amateur athletic association”, as that term is defined in section 248(1) of the Income Tax Act (the “ITA”).  He claimed a tax credit in respect of these payments under section 118.1 of the ITA as an eligible gift.  The credit was denied by the Minister of National Revenue (the “Minister”), on the basis that Mr. Fluevog had received consideration in the form of swimming lessons for his children.  As such, the payment was not a gift at law.

The proposed Charter claim arose from an administrative position of the Canada Revenue Agency (“CRA”) that permits a tax credit for payments to religious schools that solely provide religious instruction.  This position is described in Information Circular IC 75-23, which states that “it has been the Agency’s practice not to view religious instruction provided at parochial schools as consideration”.  Mr. Fluevog sought to argue that this administrative position was discriminatory on religious grounds and prohibited under section 15 of the Charter.  He took the position that the administrative policy should therefore be extended to the receipt of non-religious consideration such as swimming lessons.

The arguments at the Tax Court of Canada on the motion to amend the pleadings focused primarily on the question of whether the policy discriminated against Mr. Fluevog, such that the proposed amendments may disclose a cause of action.  As noted above, Justice Margeson ruled in favour of the taxpayer, holding that the amendment presented “at least an arguable case”.

Writing for the panel, Justice Nadon stated that the decision to grant or deny an amendment to pleadings is discretionary and is entitled to deference, barring an error in law or an improper use of discretion.  In this case, however, the decision at the Tax Court of Canada was based on an error of law.  In a brief paragraph, the Federal Court of Appeal concluded:

It is not open to the Minister to determine that a payment that is not a gift as a matter of law will nevertheless be treated as a gift for income tax purposes. If that is what the Minister has done by adopting the impugned assessing policy (and I express no opinion on that point), then the policy is wrong in law and cannot stand. But that is of no assistance to Mr. Fluevog. The remedy for adopting a policy that is wrong in law is to reject the policy, not extend it to everyone who pays for swimming lessons for their children.

As a result, Mr. Fluevog’s motion to amend his pleadings was dismissed.  There has been no word on whether Mr. Fluevog will seek leave to appeal the decision to the Supreme Court of Canada.

Justice Leslie M. Little, recently retired from the Tax Court of Canada, was interviewed by Tony Sheppard for the Fall 2011 edition of the Tax Newsletter of the University of British Columbia Faculty of Law.  Justice Little enjoyed a remarkable career with government, in private practice and then with the Tax Court.  An interview well worth reading.

The Tax Court recently released a decision dealing with the issue of whether gains realized by an unwitting participant in a Ponzi scheme are taxable.  In Johnson v. The Queen, 2011 TCC 540, the taxpayer had invested $10,000 with Andrew Lech (“Lech”).  They agreed he would invest the funds in options and pay her profits minus commissions.  The scheme paid the appellant $614,000 in 2002 and $702,000 in 2003.  However, the reality was that Lech was simply shuffling the money around between various accounts and other investors.  Further, Lech told the appellant that his family trust paid all the income tax on the investment and, therefore, the Appellant need not be concerned about paying tax.  Lech’s scheme fell apart in 2003 and he was later sentenced to jail.

The Minister assessed the Appellant for the gains she received from the scheme in 2002 and 2003.  She appealed, saying the payments were not taxable because they were not from a source of income as required by paragraph 3(a) of the Income Tax Act.  The Respondent stated that the gains were income that arose from capital she had invested with Lech, and were not windfalls exempt from tax.

The Court held that the profits from the scheme were not taxable, finding there was precious little connection between the capital invested and the gains received because the gains were taken from other investors and did not arise from any actual investment.  Further, the profits did not arise from the investment agreement with Lech because he had never intended to comply with that agreement.  Finally, the Court applied the criteria from Cranswick and held that the payments were akin to windfalls because they were funds passed on to the appellant through the fraudulent actions of Lech and did not represent a return on invested capital.

The Court also held the Minister was statute-barred from reassessing the Appellant’s 2002 taxation year in any event (although the Court found that the Appellant was careless in respect of her 2003 return, and thus if the Court found that the gains were taxable, her 2003 taxation year would have been open to reassessment).

As of the time of posting, the Crown has not filed an appeal to the Federal Court of Appeal.

It will be interesting to see how US Courts will deal with investors who profited from the Bernie Madoff scandal in 2009.  There has already been some consideration of the issue of the taxation of profits from a Ponzi scheme in earlier US jurisprudence.  In Premji (T.C. Memo. 1996-304) the US Tax Court ruled that an interest payment received from a Ponzi scheme should have been included in the taxpayer’s gross income because the payment was not a return of capital.  See also IRS CCA 200451030.

The federal government announced today that it is interested in receiving comments on proposals to improve the caseload management of the Tax Court of Canada. Specifically, the potential changes would:

• Allow a taxpayer to elect to proceed by way of the Informal Procedure where the aggregate of all amounts in issue in an income tax appeal is equal to or less than $25,000 (or where a loss does not exceed $50,000).
• Require a taxpayer to proceed by way of the General Procedure for GST/HST appeals involving an amount in dispute in excess of $50,000.
• Allow the Tax Court of Canada to dispose of one or more issues raised in an appeal separately, so that some issues can be resolved independently from others.
• Allow the Tax Court of Canada to hear a question affecting a group of two or more taxpayers that arises out of substantially similar transactions, and provide that the resulting judicial determination is binding across the group.

The Informal Procedure limits (i.e., $12,000 / loss not in excess of $24,000) have been unchanged since 1993. There is a general consensus that it is now time to increase that threshold so as to facilitate greater access to the Tax Court under the Informal Procedure.

In addition, the Tax Court has, in recent years, had to deal with an increasing number of “group appeals” but has not had the ability to bind other similarly situated taxpayers. The proposed rules would give the Tax Court greater power to deal with a growing list of group appeals in a more expeditious manner.

The Department of Finance announcement is here.

The Department of Finance backgrounder is here.

On October 28, 2011 the Tax Court of Canada released Judgment and Reasons for Judgment of the Honourable Justice Judith Woods in Global Equity Fund Ltd. v. Her Majesty The Queen, 2011 TCC 507.  Global Equity Fund Ltd. (“Global”) had appealed the application of the General Anti-Avoidance Rule (the “GAAR”) by the Minister of National Revenue (the “Minister”) to disallow the deduction of a $5,600,250 business loss incurred on the sale of shares in a private corporation. 

The Court found that the loss was produced after Global subscribed for shares of a new subsidiary corporation, which then issued preferred shares to Global which were redeemable and retractable for $5,600,250 but had a paid up capital of $56 and which resulted in an income inclusion of $56.  The stock dividend had the effect of reducing the fair market value of the shares of the new subsidiary to a nominal amount but did not affect Global’s adjusted cost base in those shares.  Global then disposed of the common shares to a newly settled family trust at a loss in the amount of $5,600,250. 

The Court did not accept Global’s argument that the transactions leading up to the loss were implemented for creditor protection purposes.  Accordingly the Court held that a number of transactions in issue were avoidance transactions within the meaning of subsection 245(3) of the Income Tax Act (the “Act”).

The Court also noted that this case was similar to two recent decisions of the Tax Court of Canada where similar strategies were used by other taxpayers to create capital losses. In both cases (Triad Gestco Ltd. v. The Queen, 2011 TCC 259 and 1207192 Ontario Ltd. v. The Queen, 2011 TCC 383) the Tax Court upheld the application of the GAAR to deny the losses.  The Court noted that both of these decisions are under appeal to the Federal Court of Appeal. 

However, in Global’s case the Court was not prepared to accept the Crown’s argument that the object and spirit of the provisions of the Act identified by the Crown evidenced a policy to disallow losses realized within an economic unit to real losses.  The Court held that Parliament did not intend that the object and spirit of provisions identified by the Crown which targeted capital losses were intended to inform as to the object and spirit of the provisions relied upon by Global in the facts of this case.

Relying on the Supreme Court of Canada decision in Canada Trustco Mortgage Co. v. The Queen (2005 SCC 54), Justice Woods held that the provisions in the Act relied upon by Global to produce the losses had not been misused and she was also unable to discern a general policy from these provisions that restricted business losses in the manner suggested by the Crown.  The Tax Court rejected the Crown’s argument that there was a general restriction against the deduction of artificially-created business losses.  For all of these reasons the Tax Court held that the Minister had not met the onus of establishing abusive tax avoidance under subsection 245(4) of the Act and allowed the appeal.

[Note: The author, along with Jehad Haymour of Fraser Milner Casgrain LLP, acted as counsel for Global - Ed.]

On October 21, 2011, the Tax Court of Canada (Justice Valerie Miller) released her decision on a motion brought by the Crown for commission evidence to be taken in California from an art dealer (see our earlier post). The Court held that the art dealer’s testimony is material to the appeal, which deals with the valuation of artwork in the context of a charitable donation program, and ordered that a Commission and a Letter of Request be issued to allow the examination of Mr. Sloan in California under section 112 of the Tax Court of Canada Rules (General Procedure).

The Court took into account the following factors in exercising its discretion to make the order:

(a) the convenience of the person whom the party seeks to examine,

(b) the possibility that the person will be unavailable to testify at the hearing by reason of death, infirmity or sickness,

(c) the possibility that the person will be beyond the jurisdiction of the Court at the time of the hearing,

(d) the expense of bringing the person to the hearing,

(e) whether the witness ought to give evidence in person at the hearing, and

(f) any other relevant consideration.

The Court was satisfied that the Crown had fulfilled the traditional tests for commission evidence, namely:

1. the application is made bona fide;

2. the issue is one which the court ought to try;

3. the witnesses to be examined can give evidence material to the issue;

4. there is some good reason why he or she cannot be examined here.

The only real issue was materiality of the dealer’s evidence.  The Crown submitted that its:

. . . theory of the case is that there was no identifiable market for the prints before Coleman, Silver and Artistic [the promoters] created a market through the donation program. Mr. Sloan is able to give evidence concerning the origins of the donation program and the absence of any discernible market for the artwork before it was packaged as part of the Artistic program. His testimony is also necessary to authenticate documents necessary to challenge the appellant’s anticipated expert evidence.

The Court also noted that the Crown is entitled “to put its best foot forward in this litigation” and should be allowed to obtain the evidence necessary to accomplish that objective.

A transfer pricing trial commenced on October 17, 2011, in the Tax Court of Canada in Toronto.  Mr. Justice Patrick Boyle will decide whether paragraph 247(2)(a) of the Income Tax Act (the “Act”) applies to the transaction at issue (the factoring of accounts receivable) to reduce the deduction of an amount paid by a Canadian corporation to a non-resident affiliate which assumed the risks of collecting the Canadian corporation’s accounts receivable.  The agreed-upon discount rate was 2.2% but the Minister of National Revenue (the “Minister”) says it would have been just over 1% had the parties been dealing at arm’s length.  The trial is expected to take approximately 6-7 weeks.  The hearing began on Monday, October 17, 2011 with an opening statement by counsel for the Appellant, McKesson Canada Corporation (“McKesson Canada”).

McKesson Canada contracted to sell its accounts receivable to a related, non-resident company, McKesson International Holdings III S.à R.L. (“McKesson International”). McKesson Canada and McKesson International agreed to a variable discount rate that would be applied to the accounts receivable.  The rate was calculated using a formula that resulted in a discount rate of 2.2% for the 2003 taxation year.  According to the terms of the agreement, all bad debt risk relating to the accounts receivable that were sold was assumed by McKesson International. The discount rate was intended to compensate McKesson International for assuming the risk that some of the accounts receivable may not be collected and would have to be written off.

The Minister disallowed a portion of the amounts deducted by McKesson Canada in respect of the discount on the sale of accounts receivable. The Minister determined that, based on the terms and conditions in the agreement, the discount rate that would have been agreed upon had the parties dealt with one another at arm’s length would not have exceeded 1.0127%. Accordingly, the Minister added some $26 million to the Appellant’s income for its 2003 taxation year, reflecting a discount rate of 1.0127% rather than the rate of 2.2% as agreed by the parties.

In his opening statement, counsel for McKesson Canada contended that the issue should be whether the discount rate agreed upon by the parties was appropriate for an arm’s length transaction given the amount of risk that was being transferred from the vendor to the purchaser of the accounts receivable and that the issue should not be what the discount rate should be if the principal terms of the contract were changed to reflect some other hypothetical agreement used by the Minister for purposes of his assessment.

In addition to the Part I appeal, there is a Part XIII appeal as well. The issue there is whether McKesson Canada conferred a benefit on its controlling shareholder, McKesson International, under subsection 15(1) of the Act by selling certain of it accounts receivable and, therefore, whether McKesson Canada should be deemed to have paid a dividend to McKesson International under paragraph 214(3)(a) of the Act. Including interest, the Part XIII assessment is approximately $1.9 million.

In conclusion, counsel for McKesson Canada argued that the Part XIII assessment is barred by virtue of the Canada-Luxembourg Income Tax Convention (1999) (the “Treaty”), which is applicable since McKesson International is a company existing under the laws of Luxembourg. As Article 9(3) of the Treaty includes a five year time limit for changes by Canada to the income of a taxpayer, the time for the adjustment expired on March 29, 2008 (before the Part XIII assessment was mailed).

The hearing continues.

For the link to the Part I Notice of Appeal, click here.

For the link to the Part I Amended Reply, click here.

For the link to the Part XIII Amended Notice of Appeal, click here.

For the link to the Part XIII Reply, click here.

On October 14, 2011, the Tax Court of Canada heard a Crown motion requesting an order for commission evidence in the case of Sackman v. The Queen (Court file 2002-4824(IT)G). The issue in the appeal is whether the amount Mr. Sackman is entitled to claim as a charitable deduction for artwork obtained from Artistic Ideas Inc. and donated to various charities is (a) the appraised value of the artwork or (b) the purchase price of the artwork.

The motion was brought by the Crown so that the Tax Court may receive the evidence of Mr. Paul Sloan (who lives in California) prior to the hearing pursuant to Section 119 of the Tax Court of Canada Rules (General Procedure). Mr. Sloan had provided works of art to Artistic Ideas Inc., which he obtained through past ownership of various art galleries in the United States.

The Crown argued that Mr. Sloan’s evidence is material. In light of the fact that Mr. Sackman obtained the artwork from Mr. Sloan, Mr. Sloan could provide evidence as to the true value of the artwork. The Crown described the test in GlaxoSmithKline Inc. v. The Queen, which sets out the factors the Tax Court will consider in determining whether to grant a request for commission evidence. The Crown submitted that the request satisfied those criteria.

Counsel for Mr. Sackman submitted that the crux of the GlaxoSmithKline test is to determine whether the evidence is relevant to the case. Counsel argued that the Crown had not provided any evidence or support, either in its written or oral submissions, to demonstrate why Mr. Sloan’s evidence will be material. Counsel also submitted that should the Court grant the request for commission evidence, Mr. Sackman would be prejudiced through yet another delay (the Notice of Appeal was filed on December 16, 2002). Finally, counsel argued that the value of the artwork was supported by reputable appraisers and the manner in which the artwork was acquired or the individual from whom it was acquired should have no bearing on the decision of the Court.

Justice Valerie Miller reserved judgment on the motion.

On September 30, 2011, The Honourable Rob Nicholson, P.C., Q.C., M.P. for Niagara Falls, Minister of Justice and Attorney General of Canada, announced the following appointment to the Tax Court of Canada:

The Honourable Randall S. Bocock, a lawyer with Evans, Philp LLP in Hamilton, is appointed Judge of the Tax Court of Canada in Ottawa, to replace Mr. Justice P. Archambault, who elected to become a supernumerary judge as of April 23, 2011.

Mr. Justice Bocock received a Bachelor of Arts (B.A.) in 1982 from McMaster University and a Bachelor of Laws (LL.B.) in 1985 from the University of Ottawa. He was admitted to the Ontario Bar in 1987.

Mr. Justice Bocock has been with the firm Evans, Philp LLP since September 1987. He has been the head of the firm’s business law department since 2000 and a member of the management committee since 2005. His main areas of practice were corporate commercial law, administrative law and estates and trust law.

Mr. Justice Bocock was an active member of the Hamilton Law Association from 1989 to 1999. He has been involved with the County and District Law Presidents’ Association since 2001 and has been Chair since 2008. He has been a member of the Canadian Association of University Solicitors since 1987. He was also executive member, vice-president and president of the McMaster University Alumni Association from 1991 to 2002. More recently, he was nominated as the director of the Lawyers Professional Indemnity Company and joined the Executive Council of the National Conference of Bar Presidents. He was the founding director and secretary of Haven of the Homeless Child, a charitable organization in Hamilton from 1999 to 2005, as well as member of the Hamilton Shelter Health Network since 2008.

This appointment is effective immediately.

On September 7, 2011, the Tax Court of Canada released its reasons for judgment in 1207192 Ontario Limited v. The Queen, the latest general anti-avoidance rule (GAAR) case to be considered by the Tax Court.

In short, the Minister applied the GAAR to deny a capital loss of $2,999,900 realized by the taxpayer in its taxation year ending February 28, 2003 on the disposition of common shares it held in a corporation (Newco).  The Tax Court (per Paris J.) found that the GAAR applied and dismissed the taxpayer’s appeal.

The facts can be briefly summarized as follows: The loss on the common shares was generated by the declaration of a stock dividend by Newco on the common shares prior to the disposition by the taxpayer.  The payment of the stock dividend had the effect of decreasing the value of the taxpayer’s common shares in Newco by an amount equal to the value of the stock dividend.  The stock dividend consisted of preferred shares with a low paid-up capital and a high redemption amount.

After the payment of the stock dividend, the taxpayer’s loss on the common shares was crystallized by a disposition of those shares to a family trust of which the beneficiaries were family members of the sole shareholder of the taxpayer corporation.  The capital loss was used by the taxpayer to offset a capital gain of $2,974,386 it realized during its 2003 taxation year.

The Tax Court concluded that (a) there was an avoidance transaction, as one of the transactions in the series was undertaken primarily to obtain a tax benefit, and (b) there was an abuse or misuse, as the transactions undertaken by the taxpayer frustrated the spirit and purpose of the capital loss provisions of the Income Tax Act (namely paragraphs 38(b), 39(1)(b) and 40(1)(b)).