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Tax Court of Canada confirms that pleadings will be struck out only in the “clearest of cases”

On December 19, 2011, the Tax Court dismissed a motion by General Electric Canada Company and GE Capital Canada Funding Company (the “Appellants”) in their current appeals (2010-3493(IT)G and 2010-3494(IT)G). The Appellants sought to strike several paragraphs from the Replies filed by the Crown on the basis that the Crown was relitigating a previously-decided matter. Justice Diane Campbell dismissed the motion but gave leave to the Crown to make a small amendment to one of the Replies.

General Electric Canada Company (“GECC”) is the successor by amalgamation to General Electric Capital Canada Inc. (“GECCI”), and GECC had inherited commercial debts owed by GECCI. GECC was reassessed and denied the deduction of fees paid to its parent corporation (“GECUS”) for guaranteeing the inherited debts. However, GECCI had previously litigated the deductibility of those fees and won (see General Electric Capital Canada Inc. v. The Queen, 2009 TCC 563, aff’d 2010 FCA 344). The current appeal involves similar issues, but with different taxpayers (GECC instead of GECCI) and tax years. In their application, the Appellants argued that the Crown was trying to relitigate issues that had been decided in the previous appeal.

The Court first dealt with the Appellant’s contention that res judicata precluded the Crown from having the issues reheard in another trial. Res judicata may take one of two forms: “cause of action” estoppel or “issue” estoppel. For either to apply, the parties in the current matter must have been privy to the previous concluded litigation. The Appellants said GECC had been privy to the decision since both it and GECCI were controlled by a common mind. The Court dismissed that argument since the appeals involve different tax years from those in the previous concluded litigation and, therefore, reflect different causes of action.

The Appellants also argued that it was an abuse of the Court’s process to relitigate the purpose and deductibility of the fees since the debt and the fee agreements were substantially the same as those in the previous concluded litigation. They asked the Court to strike out references to those agreements from the Replies. The Crown’s counter-argument was that the nature of the agreements was a live issue since it was not established that the fee agreements between GECUS and GECC were the same as those with GECCI. The Court agreed and refused to strike the sections of the Replies referring to the agreements.

The Appellants also sought to strike parts of the Replies where the Crown denied facts which the Appellants said had been proven in the previous concluded litigation. Again, the Court noted that the issues in the present appeals were different than those at issue in the previous concluded litigation, and that the Appellants did not show that the facts at issue (which were part of a joint statement of facts in the prior case) had actually been considered by the Court in the prior decision. Since the facts had not been proven they were best left to be determined later at trial.

Further, the Appellants contested two theories reflected in the Replies that they characterized as a fishing expedition. The Appellants stated these theories were not used as a basis for the original reassessment and, therefore, violated the restrictions on alternative arguments under subsection 152(9) of the Act. The Court dismissed this argument, saying that the theories were simply alternative approaches to showing that the guarantee fees paid by GECC were not deductible. The Court held they were alternative pleadings and refused to strike them out. Further, the Appellants also argued that two separate basis for the reassessments (one based on paragraphs 247(2)(a) and (c); the other, on paragraphs 247(2)(b) and (d)) should be pleaded as alternative grounds, since the two parts of that section were inconsistent with one another. This was dismissed on the basis that the two parts were complementary and were drafted in a way so that if both were satisfied, one would take precedence over the other.

Finally, the Appellants argued that they had been deprived of procedural fairness as the CRA had not consulted its own Transfer Pricing and Review Committee with respect to the reassessments, and the Appellants had been unable to make submissions to that committee. The Court held that there was no requirement that the committee consider the matter first and, even if there was, the Tax Court does not rule on administrative matters.

In the end, the Appellants succeeded on one minor point: the Crown will amend one paragraph in one Reply to clarify the distinction between legally binding guarantees and implied guarantees or support. The Crown was awarded costs.

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Tax Court of Canada confirms that pleadings will be struck out only in the “clearest of cases”

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Payments from a Ponzi scheme held to be non-taxable

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.

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Payments from a Ponzi scheme held to be non-taxable

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

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

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

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

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

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

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

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

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

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

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

Federal Court Calls CRA’s Reasons “Inadequate” on Denial of Fairness Request

On October 21, 2011, the Federal Court (Justice Sandra Simpson) released her decision on an application for judicial review in Dolores Sherry v. The Minister of National Revenue. The applicant requested judicial review pursuant to section 18.1 of the Federal Courts Act of a decision of the Canada Revenue Agency (“CRA”) in which the CRA refused to cancel or waive interest and penalties related to the applicant’s taxes for 1989 to 2000. The decision is important because the Federal Court held that the reasons provided to the applicant by the CRA were inadequate.

The applicant had sought judicial review of the refusal by the CRA and on October 25, 2005, the Minister commenced a review of the applicant’s file in accordance with the terms of an order by Justice Heneghan on April 25, 2005. Justice Heneghan made an order on consent referring the matter to the Minister for redetermination. Upon completing its redetermination, the CRA told the applicant that it declined to reduce the interest charged to the applicant from 1989 to 2000 for the following reasons:

In reviewing your financial circumstances, we conducted a cash flow analysis to determine your ability to meet your tax obligations from 1989 to 2000. In conducting this analysis we have applied the direction in the Court Order and excluded the $100,000 you reported as taxable capital gain in our cash flow analysis and included your rental loses for years 1989 to 1994 as cash outflow. Our cash flow analysis shows that your net cash flow (funds received less expenses paid during the applicable years) was sufficient to meet your tax obligations from 1989 to 2000, except for the negative cash flow years 1991, 1992, and 1993. However, we considered the fact that you had significant equity in properties that you owned during the years 1991 to 2000 and could use this equity to meet your tax obligations and to cover the negative cash flows. Therefore, your request for interest relief under financial hardship is denied.

Justice Simpson held that those reasons were inadequate as CRA “extrapolated” from her income and expenses in 2001 a cash flow summary for the years 1989 to 2000 and CRA relied, in part, on its own appraised value of the applicant’s properties when it considered whether she had equity in her real estate holdings.

Justice Simpson concluded that although the CRA’s decision, as originally communicated to the applicant, did not offer adequate reasons, a more detailed “Fairness Report” prepared by the CRA did provide an adequate explanation. Although, by the time of the hearing, the applicant had a copy of the “Fairness Report”, she was not given a copy when the CRA first told her about its decision. Therefore, the application for judicial review was allowed.

As the applicant was required to initiate a judicial review application before she received the “Fairness Report”, the Court granted her costs for the preparation of the application. Once the “Fairness Report” was secured by the applicant, the only issue on which the applicant was successful was resolved and therefore, no relief beyond the cost award was granted.

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Federal Court Calls CRA’s Reasons “Inadequate” on Denial of Fairness Request

Tax Court of Canada: The GAAR Does Not Apply to Disallow Deduction of a $5.6 Million Business Loss

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.]

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Tax Court of Canada: The GAAR Does Not Apply to Disallow Deduction of a $5.6 Million Business Loss

Capital Expenditure or Expenditure on Revenue Account? Judgment Reserved by FCA in Imperial Tobacco Canada Limited v. The Queen

As discussed in an earlier post, the Federal Court of Appeal (the “FCA”) heard submissions in Imperial Tobacco Canada Limited v. The Queen on October 26th, 2011. Justice Marc Nadon, Justice Karen Sharlow and Justice Eleanor Dawson heard the taxpayer’s appeal in Toronto.

The panel will determine whether a one-time, lump sum payment of approximately $118 million made to employees to extinguish an employee stock option plan was a deductible expense (as the taxpayer contends) or an outlay on account of capital which is precluded from deduction by paragraph 18(1)(b) of the Income Tax Act (as the Crown contends).

Imperial Canada Tobacco Limited (the “Appellant”) argued that the most important question that needed to be considered by the panel (and one that was not considered by the Tax Court of Canada) was whether there was an enduring benefit to the taxpayer. During argument, the panel was quite interested in why the Appellant agreed to facilitate the immediate vesting and exercise or surrender of all of the options to bring the stock option plan to an end. The Appellant maintained that “settling up” the stock option plan was a housekeeping matter that allowed it to satisfy its obligations before the completion of a going private transaction.

In addition to the 2007 decision of Chief Justice Donald Bowman in Shoppers Drug Mart Limited v. The Queen (“Shoppers”), the Appellant relied on three other cases (Boulangerie St-Augustin v. The Queen, International Colin Energy v. The Queen and BJ Services Company Canada v. The Queen) which permitted the deduction of expenditures incurred in the context of other corporate transactions.

The Crown argued that the cash payment to eliminate the stock option plan was a condition of the transaction and was not made in the ordinary course of the Appellant’s business. It was an extraordinary expense meant to facilitate the take-over transaction. The Crown also emphasized that the enduring benefit test should not be determinative. In this regard, the Crown relied on M.N.R. v. Algoma Central Railways, Johns-Manville Canada Inc. v. The Queen and Gifford v. The Queen.

The judgment will be eagerly anticipated as it remains to be seen whether the panel will follow the 1990 decision of the FCA in Kaiser Petroleum Ltd. v. The Queen, where it determined that a payment made to extinguish an employee stock option plan in the course of implementing a take-over transaction was a capital expenditure, or whether it will find persuasive the more recent decision of Chief Justice Donald Bowman of the Tax Court of Canada in Shoppers. In Shoppers, Chief Justice Bowman began with the proposition that “in the ordinary course a payment made by an employer to an employee for the surrender of his or her option under a stock option plan to acquire shares of the company is a deductible expense” and found that that did not change even in the context of a going private transaction.

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Capital Expenditure or Expenditure on Revenue Account? Judgment Reserved by FCA in Imperial Tobacco Canada Limited v. The Queen