27 September 2000 External T.I. 2000-EM20425 - 2000 CTF Paper - Judicial & Adm Developments

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

2000 Canadian Tax Foundation Annual Conference

36:1
Judicial and Administrative Developments
Roy Shultis, Michael Hiltz, Vance Sider, Judith Woods

Roy Shultis, CGA. Director general, Income Tax Rulings
Directorate, Policy and Legislation Branch, Canada Customs and
Revenue Agency, Ottawa.

Michael A. Hiltz. Director, Reorganizations and International

Division, Income Tax Rulings Directorate, Canada Customs and
Revenue Agency, Ottawa. BS (1964) Colorado College; LLB
(1967) University of British Columbia.

Vance Sider, CA. Partner, KPMG LLP, Toronto. BComm (1978)

McMaster University; CA (1980) Institute of Chartered
Accountants of Ontario. Former section chief, Revenue Canada
Rulings Directorate. Author and lecturer in the field of corporate reorganizations.

Judith Woods. Partner, McCarthy Tétrault, Toronto, LLB (1974)

University of Western Ontario; LLM (1978) Georgetown
University, Washington, DC. Member, Joint Committee on
Taxation of the Canadian Bar Association and the Canadian

Institute of Chartered Accountants.

Abstract

This paper consists of a transcript of a question-and-answer session involving senior officials of the Income Tax Rulings Directorate of the Canada Customs and Revenue Agency. The topics include recent court cases of interest and recent changes in the agency's administrative positions.

Keywords Rectification; penalties; leases; foreign exchange; partnerships; timing; rollovers.

The Queen v. Fortino¹

Vance Sider: In Fortino, several husband-and-wife couples owned shares of a company that was in a grocery business. The shareholders of those companies agreed to sell their shares to Loblaws and did so. As part of that sale, or in conjunction with that sale, the parties agreed that the vendors would not compete with Loblaws in the grocery business for a period of time after the sale. A separate non-compete agreement was entered into, and the purchaser made a payment to each wife and to each husband vendor with respect to that non-compete commitment. For some reason, twice the amount was paid to each husband as was paid to each wife. The Canada Customs and Revenue Agency (CCRA) assessed each husband and each wife as being in receipt of an eligible capital amount. On reconsideration, the CCRA then decided that maybe that wasn't quite right and assessed the full amount that was received by each husband and the amount received by the corresponding wife as proceeds of disposition of the husband's shares only. The CCRA did not go back to reassess the wives to remove the inclusion that they had originally assessed. Who said there is no double taxation?

Needless to say, the taxpayers went to court and argued that these amounts were not to be included in income.

The Tax Court of Canada said that the payments were not income from a source within the meaning of section 3 but were more in the nature of capital receipts. The court also indicated that they were not eligible capital amounts as the court read section 14. The court said that eligible capital amounts relate to property used in a business, and the vendors, being shareholders selling shares, were not in a business. The court more or less gratuitously commented on section 42, saying that it also did not apply because the amounts were not contingent in any way. The CCRA attempted to argue that the amount should simply be considered to be proceeds of disposition from the disposition of some sort of capital property, being a right-a right to carry on a grocery business.

The Tax Court did not allow that argument because it was not raised as one of the bases for the CCRA's assessment.

The Minister appealed to the Federal Court of Appeal, which basically confirmed the decision of the Tax Court of Canada with respect to the amounts not being income from a source under section 3, and confirmed that the Minister was not allowed to raise the argument with respect to proceeds of disposition of a right of some sort. The Federal Court of Appeal did not really comment on the section 42 remarks made by the Tax Court of Canada.

Q. 1. Would the CCRA please comment on its response to this case and the case's implications in an assessing situation?

Michael Hiltz: In this case, in conjunction with the sale by the appellants of shares of their corporation to Loblaws, the appellants executed certain non-competition agreements with Loblaws for which they received payment. At issue was the taxation of these non-competition payments.

At the Tax Court, the Crown argued alternatively that the payments should be taxable under section 3 as income from a source or under section 14 as an eligible capital amount. In her decision, the Tax Court Judge rejected both arguments and also considered an argument not raised by the Crown-that is, whether the payments should be included in income as proceeds of disposition under section 42 as an amount received as consideration for warranties, covenants, or other conditional or contingent obligations.

In her analysis, the Tax Court Judge noted that Interpretation Bulletin IT-330R, dated September 7, 1990, provides that any amount received for a non-competition covenant that is in respect of the disposition of shares comes within the provisions of section 42 as part of the proceeds of disposition of the shares. However, she declined to follow the bulletin's position and concluded that only amounts received in respect of warranties and covenants that are conditional in nature are taxable under section 42. Since the payments in issue were not conditional, section
42 was not applicable. Finally, on a procedural issue, the Tax Court Judge found that the Minister was precluded from raising the argument that the payments were taxable as capital gains under sections 38 and 39.

The Federal Court of Appeal agreed with the Tax Court that the payments were not income from a source within the meaning of section 3 of the Income Tax Act.² It also upheld the Tax Court Judge's conclusion that the Minister, having not raised the argument in his pleadings, was precluded from arguing that execution of the non-competition covenants gave rise to the disposition of capital property which would be taxable under sections 38 and 39. The Federal Court of Appeal made no mention of section 42.

It is the CCRA's view that non-competition payments will generally constitute proceeds of disposition of capital property, that being the right to compete with the purchaser.

Juliar v. AG of Canada³

Judith Woods: The next case is Juliar, a non-tax case dealing with rectification orders. A rectification order is a remedy that is available in the provincial courts to correct mistakes in documentation. A rectification order may be granted where the documentation implementing a transaction does not reflect what the parties intended. The effect of the order is that the documentation will be changed to reflect the parties' intention and the change will be binding not only on the parties but also on third parties. The relevance here, of course, is that it will be binding
on the CCRA.

The Dale case⁴ offers an example of a rectification order used for tax purposes.

In that case, the parties intended to issue shares as consideration for the transfer of property so that the transfer would qualify under section 85. It turned out that the shares had not been effectively issued because they had not been authorized for issuance. A rectification order was granted.

Juliar is another case in which a rectification order was sought. It could be a very significant case in defining the circumstances in which rectification orders are an appropriate remedy for tax mistakes.

The Juliars were a husband and wife who owned a small convenience store in Niagara Falls. The business was run in corporate form by a company called Gold's Tobacco and Variety Ltd. The transaction in which the mistake arose was a transfer by the Juliars of their shares in Gold's Tobacco to a holding company.

The transfer could have been undertaken on a tax-free basis using section 85 if shares had been issued as consideration. Unfortunately for the Juliars, that was not done, and the consideration consisted of a large promissory note. The receipt of the promissory note gave rise to a deemed dividend under section 84.1.

The Juliars gave notice to the agency and appealed to the Ontario courts for a rectification order to change the documentation so that shares were issued instead of a promissory note. The agency opposed the application on the basis that the documentation reflected what the parties had intended, the issuance of a promissory note. The Juliars argued that the documentation did not implement what they intended. They maintained that they intended a tax-free transfer to a holding company and that is not what was documented. The Superior Court of Justice in Ontario, obviously sympathetic to the plight of the taxpayers, agreed with the Juliars and issued a rectification order. That decision has been appealed by the CCRA to the Ontario Court of Appeal. The appeal was recently heard and the decision has not been issued.

Q. 1. In this particular case, notice was given to the CCRA of the rectification.

What is the CCRA's policy in terms of opposing rectification applications?

Michael Hiltz: In our view, the doctrine of rectification is applicable where it is clear that the documents that govern a transaction don't accord with the intention of the parties, but we don't accept that it can extend as far as the Juliar decision would suggest. In Juliar it seems very clear that the parties who transferred shares to the company did intend to receive a note and actually did receive it.

What they did not intend, of course, was the adverse consequences that resulted from the application of section 84.1 to what happened. The agency won't contest a rectification order where there is clear evidence that the transaction was intended to be undertaken in a particular manner but wasn't carried out in the intended fashion because of a "slip." An example of a slip would be the mistake that occurred in the Dale case. That can be described as a situation where the documentation evidencing a transaction supported that the shares should have
been issued but, because of an oversight, they were not. On the other hand, the agency would in general oppose an application for the rectification where the parties are seeking to alter transactions retroactively, solely on the basis that they resulted in a tax liability that was not intended by the parties when they were setting up the transaction. This, of course, is our view of the facts in Juliar.

Q. 2. Where a rectification order has been granted, that is not the end of the matter because in order to give effect to the rectification order, the CCRA must reverse the reassessment that was originally issued. In some prior cases, the CCRA has been reluctant to give effect to rectification orders. One example is the Dale case. What is the CCRA's position on reversing reassessments in order to give effect to rectification orders?

Michael Hiltz: The extent to which rectification orders are binding on the Minister of National Revenue has not been clearly settled by the courts. In writing for the majority in Dale, Mr. Justice Robertson suggested that the Minister would be entitled to ignore a rectification order which would have the "clear legal effect of rewriting fiscal history."5 We intend to seek clarification from the courts concerning this issue.

65302 British Columbia Ltd. v. The Queen⁶

Vance Sider: 65302 British Columbia Ltd. was all about eggs. The taxpayer produced eggs, and in British Columbia, as in most provinces in this country, you need to have a quota from the marketing board to produce eggs. This taxpayer had such a quota, but intentionally produced more eggs than allowed under the quota because it needed those eggs to supply a major customer. The marketing board imposed fines, which the taxpayer paid and sought to deduct.

This case went all the way to the Supreme Court of Canada. The taxpayer argued that these penalties were imposed because the taxpayer exceeded its quota, which it did to earn income from its business. The Supreme Court reviewed the jurisprudence on this issue, which basically reflected a two-pronged test: first of all, was the action avoidable? Second, was the action against public policy?

Basically, the Supreme Court in 65302 British Columbia Ltd. dispelled both of those tests. It does not matter if the action was avoidable, and it is not up to the courts to decide policy. That is up to the government. The Supreme Court saw nothing in the Act that provided for a different treatment of expenses in the form of fines or penalties in computing income than any other type of expense that was laid out to earn income. The Supreme Court, however, did suggest that there may be some egregious or totally repulsive situations in which it would be impossible to conclude that the action that gave rise to the fine or penalty was to earn income from business or property, but the court did not go on to explain the situations in which that might be the case.

Q. 1. Does the CCRA fully accept the Supreme Court's decision in 65302?

Roy Shultis: This issue has been the subject of some discussion for a number of years in Canada. It involves many situations, ranging from minor traffic violations to serious criminal offences. This is the CCRA's first opportunity to discuss this precedent-setting decision delivered by the Supreme Court of Canada on the proper approach to the deduction of fines and penalties from income under the Act.

Yes, we fully accept the court's judgment and will apply the provisions of the Act accordingly.

Thus, with respect to fines, penalties, and similar outlays, the criteria of "avoidable" and of "public policy," which were based on older case law, will no longer be considered requirements in interpreting paragraph 18(1)(a) of the Act. Our interpretation bulletin needs to be changed and we will either amend or cancel it shortly.

Q. 2. Has the CCRA identified any types of fines that will still, despite this case, not be allowed?

Roy Shultis: This is a very good question, and the answer depends on the judge's closing remarks: "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."7 This depends on judgment and values, and breeds uncertainty and inconsistency in administering the legislation.

The Supreme Court has decided that, in general terms, cases where we can legally deny the deduction for fines and penalties will be limited to rare situations for which the CCRA has not yet developed any guidelines. When the bulletin is revised, hopefully we can be more precise.

Cases with which we might be concerned could include those where sharply defined national interests are violated, examples of which could include environmental protection or criminal offences. Some offences, such as driving under the influence, may be personal expenses of the employee or officer and thus not deductible under paragraph 18(1)(a).

Q. 3. It might help us to look at the recent decision in McNeill v. The Queen⁸ to try to determine what the CCRA's policy will be. In McNeill, I'm afraid it was Mr. McNeill who had egg on his face. Mr. McNeill was a chartered accountant.

He sold his practice and agreed not to compete with the purchaser for a period of five years within a specified geographic area. But he found that he needed more money and decided to go ahead and compete anyway. He set up shop outside the geographic area but clearly did business with clients within the geographic area.

The purchaser of the business successfully sued Mr. McNeill, and damages were awarded. Mr. McNeill sought to deduct those damages in computing his income.

McNeill is a Federal Court of Appeal decision; it followed 65302 British Columbia Ltd. and cited it. While Mr. McNeill's actions were reprehensible, the Federal Court of Appeal did not feel that they were egregious or totally repulsive, and therefore allowed the deduction. Do you agree with the McNeill decision?

Roy Shultis: Yes, as long as the outlay is on account of income, and not a capital outlay.

Q. 4. Does the CCRA have any tax policy concerns that arise as a result of the decision of the Supreme Court in 65302 British Columbia Ltd.?

Roy Shultis: The CCRA will, of course, leave the ultimate resolution of the tax policy issues with the Department of Finance.

It is the CCRA's opinion, however, consistent with the court's conclusions, that the preferred way to provide for the disallowance of the deduction of payments in situations deemed to violate public policy is through the introduction of amendments to the current legislation.

I understand that the United States, when faced with the same issue, made legislative amendments to codify restrictions on the deductibility of payments based on public policy grounds, such as punitive damages, bribes, fines and penalties, and expenditures in connection with the illegal sale of controlled substances.

In Canada, some restrictions on the grounds of public policy have been codified in the Act, leaving much of the debate to the courts. They include:

• section 67.5, disallowing the deduction of bribes and any similar outlays;
• paragraph 18(1)(t), denying the deduction of any amount, including interest and penalties, such as those in subsection 163(2) or section 163.2, payable under the Act; and paragraph 18(1)(l.1), disallowing any payments under the Petroleum and Gas Revenue Tax Act.

Q. 5. Could you summarize our discussion?

Roy Shultis: The CCRA accepts the Supreme Court of Canada's decision. There are few exceptions on deductibility issues relating to fines and penalties, and we will try to provide more clarification when the bulletin is revised. We will work with Finance as it pursues what proper tax policy should be reflected in the legislation.

Construction Bérou Inc. v. The Queen⁹

Judith Woods: This case deals with the circumstances in which a lease can be recharacterized as a sale. The CCRA's position, stated in Interpretation Bulletin IT-233R, has been that where a lease has a purchase option with an exercise price at less than fair market value, the lease will be considered a sale. This bulletin is almost 20 years old and has been the subject of much criticism. Essentially, it
applied a substance-over-form approach that hasn't been supported by the jurisprudence.

There have been some recent developments in the courts on the issue of substance over form, and of course the Shell decision¹⁰ is the leading case in that area.

Despite the criticism of the interpretation bulletin, in 1995 the CCRA announced that it would continue to follow the bulletin until a number of court cases on the issue made their way through the system. The Bérou case was decided by the Federal Court of Appeal in 1999.

In Bérou, the taxpayer had entered into leasing contracts for trucks and argued, against its own form, that the leasing contracts resulted in an acquisition of the trucks for tax purposes. Accordingly, the taxpayer claimed capital cost allowance and investment tax credits. The leasing contracts had many of the characteristics of a transfer of ownership, one of the key features being a purchase option at less than fair market value.

The Federal Court of Appeal was split on the issue of the characterization of the leasing contracts. The majority agreed with the taxpayer, holding that the contracts really constituted sale contracts. The dissenting judge basically said that a lease is a lease. The majority decision cited a number of factors, including differences between civil law and common law respecting leases and sales. There was also some evidence of a substance-over-form approach by the majority.

Q. 1. In light of this case, does the agency now feel it can review Interpretation Bulletin IT-233R, dated February 11, 1983?

Roy Shultis: The agency is planning to withdraw IT-233R, but before doing so we will provide an opportunity to give comments on the implications this may have for the variety of financing transactions undertaken in the marketplace.

Q. 2. Why are you taking this position?

Roy Shultis: The positions in the bulletin were intended to curb abuses in leases in situations where the substance of the transactions disclosed that the parties intended to effect a sale. As we said at the 1988 annual conference and in Income Tax Technical News no. 5, the bulletin was not meant to be used by taxpayers to avoid the legal consequences of their own transactions.

However, the Supreme Court has held, in Shell and other decisions, that the economic realities of a situation cannot be used to recharacterize a taxpayer's bona fide legal relationships. It has held that, absent a specific provision of the Act to the contrary or a finding that there is a sham, the taxpayer's legal relationships must be respected in tax cases. Thus, generally and subject to GAAR, recharacterization is permissible only if the label attached by the taxpayer to the particular transaction does not properly reflect its actual legal effect.

Thus, it is now our view that the determination of whether a contract is a lease or sale is based on the legal relationship created by the terms of the agreement, rather than on any attempt to ascertain the underlying economic reality.

Therefore, in the absence of sham it is our view that a lease is a lease and a sale is a sale. However, notwithstanding the legal relationship, GAAR may be used to assess cases in which there is an avoidance transaction that results in a misuse or an abuse of provisions of the Act. As in the Canadian Pacific¹¹ case that is before the courts, we will respect legal relationships but will apply the GAAR where an avoidance transaction results in a misuse or abuse.

This is not to say that a contract that is called a lease will necessarily be a lease. For example, if the "lessee" automatically acquires title to the propertyafter payment of a specified amount in the form of rentals, the legal relationship between the parties would be one of purchaser-vendor rather than that of lessee-lessor.

In essence, it would be a conditional or instalment sales contract.

Withdrawal of the bulletin will ensure consistency between the CCRA's position on lease characterization for the purposes of Part I of the Act and for the purposes of Part XIII withholding tax, Part I.3 large corporations tax, and the goods and services tax.

I would ask that any comments you wish to make concerning the implications of this position be submitted in writing by the end of this year.

Q. 3. Will taxpayers who entered into leasing transactions before the cancellation of the bulletin and who relied on its criteria to determine their filing position be "grandfathered" from changes to the CCRA's position?

Roy Shultis: In this case, grandfathering status appears to be questionable since, as stated at the 1988 conference and in Income Tax Technical News no. 5, the application of the criteria published in IT-233R was meant to be an assessing policy and was not intended to allow taxpayers to determine their filing position by claiming that the form of their agreement does not reflect the true legal relationship, particularly where the result would be that two taxpayers owned the same property. However, we will base any transitional guidelines on the comments
we receive.

Q. 4. Is the CCRA's proposed action contrary to recent jurisprudence on financial leases? Construction Bérou is a recent example.

Roy Shultis: We don't think so. In Construction Bérou, the Federal Court of Appeal emphasized the importance of applying the Act uniformly to everyone, whatever the legal system. In doing so, it concluded that the position in IT-233R, as it applied in the relevant period-namely, in 1982-applied to all taxpayers at that time. The court did not make any comments on how the question would be

resolved if the transactions were carried out at the present time.

In light of the Supreme Court's views on the matter of legal form over substance as evidenced in recent jurisprudence, subject to GAAR, recharacterization is permissible only if a transaction does not reflect its actual legal effect or if a specific provision of the Act provides that the legal relationship need not be respected. With respect to earlier court cases on the matter of financial leases, we believe that the courts would look favourably at this approach over the economic reality of transactions if they were submitted at the present time.

Q. 5. As you pointed out, absent a specific provision of the Act to the contrary, a taxpayer's established legal relationships must be respected in tax cases. Do you have an example of a situation in which you would consider a lease arrangement to be a sham?

Roy Shultis: While we do have ongoing cases where the potential for a sham argument is being considered, the typical financial lease would not generally be considered a sham. In fact, the Act recognizes the validity of financial leases since it has been amended to specifically deal with aspects of them (for example, the specified leasing rules (regulation 1100(1.1)), section 16.1, and subsections 13(5.2)-13(5.4)).

Q. 6. What notice will you give tax practitioners before the change is implemented?

Roy Shultis: The CCRA is planning to announce its position in the Income Tax Technical News and in an interpretation to be published on our Web site.

Olsen v. The Queen¹²

Vance Sider: The facts are rather simple. Mr. Olsen owned a company by the name of Leader and sold some of the shares of the company to a company owned by his children, which I'll refer to as P Co here. P Co did not own, as a result of the sale, 10 percent of the votes and value of Leader. Mr. Olsen took back boot, but filed his tax return on the basis that section 84.1 did not apply because, in his determination, Leader was not connected with P Co. Subsection 186(4) says that Leader is connected with P Co if P Co owns more than 10 percent of the votes and value of the shares of Leader or if P Co controls Leader. For the purposes of subsection 186(4), there is another provision, subsection 186(2), that
says, for the purposes of determining control for the purposes of Part IV, a company is considered to own shares held by a non-arm's-length person. So if you superimpose subsection 186(2) over subsection 186(4), P Co is deemed, by virtue of subsection 186(2), to own the shares of Leader that were owned by Mr. Olsen, a non-arm's-length person, and consequently P Co is considered to control Leader.

Thus Leader is considered to be connected with P Co for the purposes of Part IV.

The Tax Court of Canada said that section 84.1 did not apply, and that even though, for the purposes of Part IV, Leader may have been connected with P Co, for the purposes of section 84.1, subsection 186(2) is not relevant. Subsection 186(2) is relevant for the purposes of Part IV; section 84.1 is not in Part IV, but in Part I.

Q. 1. Has the CCRA accepted this decision and what might the implications of this be?

Michael Hiltz: The CCRA is of the view that, having regard to the context and legislative intent of the provisions in question, whether corporations are connected for the purposes of subsection 84.1(1) can and should be determined with reference to subsection 186(2). The Olsen decision has been appealed to the Federal Court of Appeal.

Cobb v. The Queen¹³

Judith Woods: Cobb was an informal decision of the Tax Court of Canada dealing with the determination of the source of employment income. The reason the case is given prominence in this panel is that it deals with a rather common situation in which the CCRA's position is not at all clear based on the jurisprudence.

Mr. Cobb was an ordained minister who worked for a charitable organization based in the United States. He was a resident of Canada and spent 75 percent of his time in Canada. In his Canadian tax return, Mr. Cobb claimed a foreign tax credit in respect of US social security taxes paid. He took the view that all of his employment income was sourced in the United States.

The Tax Court agreed with Mr. Cobb and allowed the foreign tax credit. The court relied on an old 1925 House of Lords decision called Foulsham v. Pickles.¹⁴ Surprisingly, Foulsham held that in determining the source of employment income, the place where the duties are performed is an irrelevant factor. The relevant factors include such things as where the remuneration is paid.

Q. 1. Does the CCRA intend to follow the Cobb decision?

Michael Hiltz: We won't be following the Cobb decision. This was an informal decision of the Tax Court of Canada. The taxpayer was a US citizen. He was also employed by the Ford Mission Board, which was a US charitable organization.

In 1994 and 1995 the taxpayer resided in Canada and worked in Canada for 75 percent of the year. He worked in the United States for 25 percent of the time.

The taxpayer was paid by the Ford Mission Board by deposits made into his US bank account. The taxpayer paid US social security tax and sought a foreign tax credit on the amount paid.

The CCRA argued that the source of the income earned from working in Canada was Canada. This position is found in IT-270R2, dated February 11, 1991, at paragraph 28: "The territorial source of income from an office or employment is considered to be the place where the related duties are normally performed."

The Tax Court relied on Foulsham v. Pickles, which held that the place where the tasks or work is performed is immaterial. The court found that because no money was generated in Canada accruing to either the employer or the taxpayer, the source of the taxpayer's income was in the United States. Therefore, the taxpayer was entitled to foreign tax credits in Canada in respect of the US social security tax paid on his employment income.

Cobb is inconsistent with Shere v. MNR.¹⁵ In Shere, the taxpayer was employed by a Canadian Crown corporation in New York. His salary was deposited in Canadian funds in a bank account in Montreal. The issue was whether the employment income was sourced in the United States. The court in Shere did not follow the decision in Foulsham. The court stated that neither the place where a contract of employment is entered into nor the fact that the employee is paid at a different location from the one in which he performs his normal duties determines the territorial source of his income. The court concluded that the source of income was where the duties were performed.

Support for this position is also found in paragraph 4(1)(b) of the Act, which deals with a taxpayer who carries out employment duties partly in one place and partly in another. Paragraph 4(1)(b) states that the taxpayer's income from the duties performed in a particular place shall be computed as if the taxpayer had no other income and was allowed no deductions except for deductions wholly applicable to those duties. This paragraph is relevant for the foreign tax credit computation in section 126 of the Act.

If we encountered a similar situation again, we would assess following the reasoning in Shere.

Irving Oil Ltd. v. The Queen¹⁶

Vance Sider: The taxpayer made an overpayment of tax due to an error by the Minister and, as a result, in due course received refund interest. The taxpayer included the interest received on the refund in its active business income and in its adjusted business income for purposes of computing the taxpayer's manufacturing and processing (M & P) deduction. The Tax Court of Canada determined that the funds that had been loaned, effectively, to the government would probably have otherwise been used in the taxpayer's M & P activities and therefore concluded that the refund interest was properly included in its adjusted business income for purposes of computation of the M & P tax credit.

Q. 1. Does the CCRA accept this decision?

Roy Shultis: No, we have appealed this decision.

The CCRA does not accept that refund interest from overpayment of income tax can be included in active business income or adjusted business income. It is our view that such refund interest constitutes income from property. The scheme of the Act is such that refund interest on income tax overpayments is not received in the course of carrying on an active business. It is received after the business activity is completed and income tax is assessed on the income from the business activity.

The decision of the Tax Court of Canada in the Irving Oil Limited case has raised doubt about our position. In the decision from the court, Judge Rip decided that the refund interest received by the taxpayer was business income. The judge conducted a "scheme of the Act" analysis and concluded that refund interest will be interest from a business if the origin of the funds that were used to pay the related income tax overpayment was from the business of the taxpayer, and if the "probable intended use" of those funds (in the absence of an assessment) would have been the business of the taxpayer.

The reasoning of Judge Rip is consistent with that of Judge Bowman in Munich Reinsurance Co.,¹⁷ in which the taxpayer's appeal was dismissed. Both judges are of the view that it is a question of fact whether refund interest is income from a taxpayer's business, and both judges conclude that, on the facts before them, the refund interest is income from the taxpayer's business.

This case is important because refund interest received by companies (except companies that have resource activity) would be taxed at the lower income tax rate that applies to M & P companies.

At the time when companies in the mining and oil and gas sectors were receiving large amounts of refund interest on income tax overpayments and similar non-deductible payments, a specific legislative amendment was made, for greater certainty, to ensure that such companies would not be able to increase their M & P deduction with respect to such refund interest. These amendments were not to be construed as implying that the receipt of refund interest previously had the result of increasing entitlement to the M & P deduction.

In light of the uncertainty raised by the decision of the Tax Court of Canada, we are seeking clarification of the issue from the Federal Court of Appeal.

Lussier v. The Queen¹⁸

Vance Sider: Ms. Lussier was a beneficiary of a testamentary trust. The trust tax returns and Ms. Lussier's own tax returns were prepared by an accountant. The income of the trust was paid out to Ms. Lussier in the year, and the accountant prepared the returns to reflect that the income that had been distributed to her was included in her income and not included in computing the income of the trust. The next year she went to a different accountant who prepared the tax returns for the next year on a different basis. Since this was a testamentary trust, and could use graduated rates of tax, tax would be saved if the income, although distributed to the beneficiary, was taxed in the trust and not in the beneficiary's hands. So the new accountant prepared the returns on the basis that subsection 104(13.1) applied and made the designation to effectively have the income that was distributed to the beneficiary included in the trust's income for tax purposes.

Furthermore, the accountant sent a letter to the CCRA requesting that the trust's return be amended for the previous year to recognize the subsection 104(13.1) election. The beneficiary also requested a reassessment of the previous year to exclude from her income the amount that had been distributed to her.

The Minister contended that subsection 104(13.1) provides that this designation must be made when the return is filed. The Tax Court of Canada characterized this, surprisingly, as an honest mistake, and not as retroactive tax planning.

The court concluded that the trust effectively made an honest mistake in inappropriately computing its income and claiming a deduction for the amount that had been distributed to the beneficiary. The trust should have made the subsection 104(13.1) designation, which would have been to the advantage of the beneficiary.

The court said that the amended return may be made by way of letter, and that the subsection 104(13.1) election may be made in an amended return; it does not need to be made in the original return. However, the Minister is not obliged to reassess in such circumstances. The court adopted Mr. Justice Robertson's statement in Nassau Walnut¹⁹ that in this case the Minister's refusal was "antithetical
to elemental concepts of fairness," which I think means that it is in direct contrast to basic concepts of fairness. The court ordered the Minister to reassess.

Q. 1. Does the CCRA accept the decision of the Tax Court in Lussier?

Roy Shultis: The law provides a mechanism that allows a trustee to choose to have trust income, which was distributed to a beneficiary, taxed in the trust rather than in the hands of the beneficiary who received the income. Since the law does not provide for amending, late-filing, or revoking this particular designation, it was our position that it had to be filed with the return of income.

However, we do accept the Tax Court of Canada's decision in Lussier, and are of the view that such a designation may be amended, late-filed, or revoked where the trustee can establish that an honest mistake was made. The fact that an honest mistake was made was an important part of the decision. However, we will not reassess to reduce the income of the beneficiary in situations where a corresponding adjustment cannot be made to the trust return because the year is statute-barred.

An example of an honest mistake could include a situation where a taxpayer was not aware of the designation, or where the designation results in unintended tax consequences, and there is evidence that the taxpayer took reasonable steps to comply with the law and undertook remedial action as quickly as possible. On the other hand, retroactive tax planning will not be accepted.

Our comments contained in the T3 Guide, which say that no amendment, revocation, or late-filing of the designation will be allowed, will be amended when the guide is next revised.

We will recommend that this election be prescribed under regulation 600.

Requests to amend, late-file, or revoke the designation should be made in writing to the Estate Returns Processing Section at the Ottawa Technology Centre.

I have been advised that since these requests will be reviewed on a case-by-case basis, each request has to include the name and account number of the trust, the names and addresses of the trustees and beneficiaries, and a full explanation of why the designation is being amended, late-filed, or revoked.

Q. 2. In Information Circular 75-7R3, dated July 9, 1984, paragraph 4 sets out the conditions in which the CCRA has agreed to amend a return in circumstances where it is not required to and in circumstances in which the taxpayer would receive a refund. The conditions set out in that circular are, basically, that the tax return must have been filed; it cannot be statute-barred; the adjustment sought must not relate to a discretionary claim that was not claimed (for instance, capital cost allowance that was not claimed that the taxpayer now seeks to claim); the issue must not be as a result of a decision of the courts in relation to another taxpayer; and, finally, the CCRA must be satisfied that the previous assessment was wrong. In looking at those criteria, I wonder which criterion was not satisfied in the case of Lussier. I suspect maybe it was that the CCRA was not satisfied that the previous assessment was wrong, because in its view the subsection 104(13.1) election must have been made in the original return. Is the CCRA considering any change to the circular as a result of this decision? Will the CCRA comment on its position with respect to elections or designations by way of amended returns?

Roy Shultis: I consulted with my colleagues in Audit, and they are presently not considering any modification of the criteria outlined in paragraph 4 of Information Circular 75-7R3 as a result of the Lussier decision. The CCRA's position with respect to elections or designations is set out in Information Circular 92-1, dated March 18, 1992.

The Queen v. MacMillan Bloedel Limited²⁰

Vance Sider: Most of us are familiar with the MacMillan Bloedel case. The facts are very simple. The taxpayer issued preferred shares denominated and redeemable in US dollars. On the redemption of those shares, the Canadian dollar equivalent of the redemption amount, not surprisingly, exceeded the Canadian dollar equivalent of the amount it had received when the shares were issued. As a result, the taxpayer considered that a loss had been incurred. More money was paid out on the redemption than had been received on the issuance of the shares. Both the Tax Court of Canada and the Federal Court of Appeal, to the surprise of some, including myself, concluded that this was a capital loss under subsection 39(2), and basically equated the situation to that of the issuance of debt.

Q. 1. The CCRA has indicated that it has accepted this decision but has qualified it and limited it to situations where the shares in question are high paid-up capital, fixed-value, foreign-currency-denominated shares. Would the CCRA extend that position to a situation where, depending on the facts, it may be quite clear that the corporation has paid out more on redemption or purchase for cancellation than it otherwise would have had to had there been no foreign currency fluctuation, but where the shares are not foreign-currency-denominated, fixed-value, high paid-up capital shares?

Another issue that arises from the MacMillan Bloedel case is the application of subsection 84(3) and whether or not a deemed dividend arises on the redemption of such shares, and furthermore, how that dividend would be computed. Subsection 84(3) refers to the paid-up capital of the shares immediately before redemption and compares that to the redemption amount. If the paid-up capital of the shares is denominated in foreign currency, does the CCRA consider that the paid-up capital immediately before redemption is simply the foreign currency amount converted to Canadian dollars immediately before redemption, in which case no dividend would likely arise, or does the CCRA consider that the
paid-up capital immediately before redemption is the paid-up capital in foreign currency, but computed or converted to Canadian currency at the time of the issuance of the shares?

Michael Hiltz: The CCRA accepts the reasoning in the MacMillan Bloedel decision and intends to assess any redemption of foreign-currency-denominated redeemable and retractable high paid-up capital preferred shares on the basis of that reasoning regardless of whether the result is a capital gain or a capital loss under subsection 39(2). However, it is not clear whether the reasoning in this decision could be applied to an acquisition of other shares where the acquisition price is greater than the issue price in foreign currency, but is not determined by the terms of the shares. In such a case there is no clear benchmark against which to determine whether a foreign currency gain or loss has occurred on the shares' repurchase.

In reference to the application of subsection 84(3), at the Federal Court of Appeal the taxpayer conceded that a deemed dividend arose pursuant to the provisions of subsection 84(3) notwithstanding the fact that, expressed in US dollars, the redemption amount was equal to the paid-up capital of the shares. We would not be surprised to see this issue raised in another case by a shareholder who owns shares denominated in a foreign currency.

The CCRA does not consider the decision in MacMillan Bloedel to interfere with its position that, in cases involving the disposition of capital property where the application of section 40 does not result in a gain or loss, there is no gain or loss for the purposes of subsections 39(1) and 39(2). The CCRA also maintains its view that in reference to a gain or loss from the disposition of property, subsection 39(2) will apply only if the gain or loss is solely attributable to the fluctuation of the currency of a country other than Canada relative to Canadian currency.

Provigo Distributions Inc. v. The Queen²¹

Vance Sider: In Provigo, the taxpayer sought to deduct payroll taxes in the year to which the salaries related. The CCRA's position has always been, I understand, that payroll taxes are deductible when the salaries are paid because it is at that point in time that the legal obligation to remit the payroll taxes arises. Provigo had several hundred thousand dollars in payroll taxes relating to the first payroll period that ended in 1993, most of which related to 1992. Provigo deducted the payroll taxes in 1992 that related to the salaries that were earned in 1992 but paid in 1993. The CCRA challenged the deduction. The Tax Court of Canada concluded that the payroll taxes were deductible in 1992 because there was a legal obligation to pay them that arose as the salaries were earned, even though the remittance of the payroll taxes may not have been due until 1993.

Q. 1. Has the CCRA accepted the decision in Provigo?

Roy Shultis: Our decision to appeal this case is under reconsideration.²² In general terms, an expense is allowed under paragraph 18(1)(a) when the amount is "incurred." In applying this test in Provigo, the CCRA's position was that an expense is incurred when there is a legal obligation to pay an amount.

The CCRA had disallowed the contributions for payroll deductions to the extent that they related to unpaid salaries during the last week of 1992 and paid in the first week of 1993. Thus, it was a timing adjustment. Our position was based on the premise that there was no legal obligation until the underlying salaries were actually paid. However, we are reviewing the court decision and the facts in this case to determine whether the payroll deductions relating to the unpaid salaries meet the tests for deductibility, as noted above.

The services in this instance had been rendered and the salaries had become payable and, under the particular laws that gave rise to the withholding taxes, the court decided that the employer's assessments for payroll deductions arose for work done by the employees and not when the salary was paid.

Q. 2. How does the CCRA distinguish Provigo from Fédération des Caisses Populaires v. The Queen,²³ where the Tax Court of Canada supported the CCRA's Position that payroll deductions related to vacation pay were not deductible during the period in which the vacation was earned?

Roy Shultis: First of all, I would like to note that, while the outcome was favourable to the CCRA in Caisses Populaires, the taxpayer has appealed the decision to the Federal Court. Therefore, I likely should not make any comments on this question but I will try to provide some clarification. In Caisses Populaires, the particular withholding deductions were held by the court to be contingent amounts and specifically not allowed under paragraph 18(1)(e) of the Act. These withholding taxes related to vacation pay that was earned in the year for vacation to be taken in subsequent years. This case will of course be reviewed in light of our decision in Provigo. However, there is a difference between accrued vacation pay and accrued salary. Vacation pay is a promise to pay salary when vacation is in fact taken at some future date. I would have thought that the liability for the withholding deductions does not arise until the vacation is taken.

Paragraph 85(1)(b)

Michael Hiltz: Revenue Canada stated in its answer to question 47 at the Revenue Canada Round Table at the 1984 annual conference of the Canadian Tax Foundation that paragraph 85(1)(b) does not apply to a transfer of a property with liabilities in excess of cost amount where the excess is allocated to another property or is assumed by the purchaser in consideration for the delivery by the vendor of a promissory note in the amount of the excess. At the Revenue Canada Forum at the 1996 Corporate Management Tax Conference, Revenue Canada indicated
that this position was under review.

The review has now been completed. Where, after 2000, a property ("the first property") is transferred pursuant to the provisions of section 85, and:

1) the purchaser assumes an obligation of the vendor as consideration for the acquisition from the vendor of a second property (for example, a note of the vendor) and the purchaser subsequently disposes of that property to the vendor,

2) the purchaser assumes an obligation of the vendor as consideration for the redemption or acquisition by the purchaser of its shares held by the vendor,

or

3) the purchaser subscribes for shares of the vendor,

the obligation so assumed or the property so contributed will be regarded as con-sideration for the first property. Thus, if the total non-share consideration so considered to have been given by the purchaser for the first property exceeds the amount agreed upon by the vendor and purchaser in their election under subsection 85(1), paragraph 85(1)(b) will apply to increase the amount agreed upon.

Consider the situation, for example, where the purchaser assumes an obligation of the vendor as consideration for a note of the vendor. Assume that Sellco has a capital property with a cost amount of $200 and a fair market value of $1,000 and a mortgage on the property of $700. Sellco transfers the $1,000 property to Buyco pursuant to section 85 and issues Buyco a promissory note for $500. The agreement between Sellco and Buyco provides that, as consideration for the capital property, Buyco will assume $200 of the mortgage liability and will issue to Sellco $500 worth of redeemable preference shares and $300 worth of common shares and that, as consideration for the promissory note issued by
Sellco, Buyco will assume $500 of the mortgage liability of Sellco. At some time after the transfer, Buyco redeems the preference shares by surrendering the promissory note to Sellco and reports the redemption proceeds as a deemed dividend.

In the CCRA's view, the entire amount of the mortgage assumed is assumed as consideration for the transferred property. Sellco has received non-share consideration on the transfer of $700, and this is the lowest amount that could be elected in respect of the transfer under section 85.

Consider also the following alternative situation using the same initial facts, but involving the redemption of the shares of the purchaser held by the vendor.

On the initial transfer of the subject capital property, Buyco issues class A preferred shares, which are redeemable for $300, and class B preferred shares, redeem-able for $700. Following the transfer, Buyco redeems the class B shares. The consideration given upon the redemption is the assumption of the $700 mortgage.

In the CCRA's view, the entire amount of the mortgage assumed is assumed as consideration for the transferred property. Sellco has received non-share consideration on the transfer of $700, and this is the lowest amount that could be elected in respect of the transfer under section 85.

As a final example, consider again the same initial facts, except that Buyco borrows $700, which it uses to subscribe for shares of Sellco. Sellco uses the $700 to repay its mortgage liability. Sellco then transfers the $1,000 property to Buyco for shares of Buyco and elects at $200 under section 85. Buyco repurchases $700 of its shares held by Sellco, and Sellco pays $700 to Buyco as a return of capital. The $700 capital contribution to Sellco by Buyco will be regarded as consideration for the transferred property such that paragraph 85(1)(b) will apply to deem the elected amount to be $700.

The CCRA confirms its view that paragraph 85(1)(b) does not apply to increase proceeds if the fair market value of the non-share consideration given (including the assumption of debt by the purchaser) is allocated among several properties transferred to and retained by the purchaser and the amount allocated to each asset is not greater than the amount elected in respect of each asset.

Delaware Revised Uniform Partnership Act

Vance Sider: The next and final issue deals with the Delaware Revised Uniform Partnership Act (DRUPA). Last year, Delaware introduced a statute that has raised some concern among some as to whether or not entities that are subject to DRUPA might be considered by the CCRA to be corporations as opposed to partnerships.

The statute is effective for partnerships created after 1999, but is only effective after 2001 for entities created before 2000. There is basically a two-year grandfathering period for entities that were created before 2000, but those created after 1999 are subject to DRUPA immediately. The concern with respect to entity classification arises because of some of the provisions in DRUPA that refer to partnerships being separate legal entities, and to ownership of property being that of the partnership and not the partners. There is also an opt-out provision.

Q. 1. Has the CCRA reached a decision on the status of entities subject to DRUPA?

Roy Shultis: We originally opined that a partnership governed by DRUPA was a corporation for Canadian tax purposes, but we are now reconsidering the issue.

We have not released this opinion to the public. We have not reached a final decision on the status of a partnership governed by DRUPA. We have obtained additional information to analyze the issue, and we have sought legal advice from the Department of Justice.

This issue is an important one, as our eventual position will not only affect the status of the general partnerships created under the Delaware legislation but also partnerships formed in other states of the United States where the government has adopted or is in the process of adopting similar versions of the Revised Uniform Partnership Act.

We will announce our position in the Technical News.²⁴

Q. 2. What approach are you using to reach a decision?

Roy Shultis: A full analysis must be made of the foreign partnership statute to determine the attributes of an entity formed under that statute. These attributes must then be compared to the attributes of a Canadian partnership and a Canadian corporation.

A decision is then made on whether the foreign partnership more closely resembles a partnership or a corporation under Canadian law.

Q. 3. What tests do you consider to be relevant in reaching your determination?

Roy Shultis: Our initial concern as to the status of the general partnerships governed by DRUPA comes from the fact that a partnership governed by this legislation is a separate legal entity that is distinct from its partners unless otherwise provided in a statement of partnership existence and in a partnership agreement.

Furthermore, many provisions in DRUPA suggest that partnerships to which it applies have a separate legal existence, including a provision that a partnership may sue and be sued in the name of the partnership and a provision that property acquired by a partnership is property of the partnership and not of the partners individually. Taken in isolation, these characteristics, in and by themselves, appear to suggest that these partnerships are in fact corporations for Canadian tax purposes.

However, a general partnership governed by DRUPA has additional characteristics that are similar to the characteristics of a partnership. One of them is that although the partnership is a separate legal entity, all partners are liable jointly and severally for all obligations of the partnership unless otherwise agreed by the claimant or provided by law.

Another characteristic is that each partner is entitled to an equal share of the partnership profits and is chargeable with a share of the partnership losses in proportion to the partner's share of the profits. Each partner is deemed to have an account that is charged, inter alia, with an amount equal to the partner's share of the partnership losses and has to contribute to the partnership an amount equal to any excess of the charges over the credits in the partner's account upon the winding up of the partnership's business or affairs.

Furthermore, a person may become a partner only with the consent of all of the partners. Under DRUPA, only a partner's economic interest may be transferred.

The rules applicable where there is a transfer of a partner's economic interest are similar to the provisions contained in the partnership legislation of several Canadian provinces concerning an assignee.

These are only a few examples of the provisions contained in DRUPA that are being considered in deciding whether a general partnership governed by DRUPA is a corporation or a partnership for Canadian tax purposes.

Notes

^1. 2000 DTC 6060 (FCA), 97 DTC 55 (TCC).

^2. Income Tax Act, RSC 1985, c. 1 (5th Supp.), as amended (herein referred to as "the Act").

Unless otherwise stated, statutory references in this paper are to the Act.

^3. 99 DTC 5743 (Ont. SCJ). Subsequent to this conference, on October 6, 2000, the Ontario
Court of Appeal dismissed the appeal of the Attorney General of Canada.

^4. Dale et al. v. The Queen, 97 DTC 5252 (FCA).

5. Ibid., at 5256.

^6. 99 DTC 5799 (SCC).

^7. Ibid., at 5813.

^8. 2000 DTC 6211 (FCA).

^9. 99 DTC 5868 (FCA).

^10. Shell Canada Ltd. v. The Queen et al., 99 DTC 5669 (SCC).

^11. Canadian Pacific Limited v. The Queen, 99 DTC 5132 (FCA).

^12. 2000 DTC 2121 (TCC).

^13. 2000 DTC 1674 (TCC).

^14. [1925] AC 458 (HL).

^15. 89 DTC 201 (TCC).

^16. 2000 DTC 2164 (TCC).

^17. Munich Reinsurance Co. v. The Queen, 2000 DTC 2009 (TCC).

^18. 2000 DTC 1677 (TCC).

^19. The Queen v. Nassau Walnut Investments Inc., 97 DTC 5051, at 5057 (FCA).

^20. 99 DTC 5454 (FCA).

^21. 2000 DTC 2112 (TCC).

^22. Subsequent to the conference, the CCRA withdrew its appeal in Provigo.

^23. 2000 DTC 1585 (TCC).

^24. Subsequent to this conference, the CCRA has taken the view that the attributes of an entity formed under the DRUPA, through which its members carry on business in common with a view to profit, more closely resemble those of a general partnership under Canada's common law than those of a Canadian corporation. Therefore, an entity governed by the DRUPA would generally be treated as a partnership for Canadian income tax purposes.