Shell Canada Ltd. v. Canada, 99 DTC 5669, [1999] 3 SCR 622, [1999] 4 CTC 313

McLachlin J.:

This appeal by Shell Canada Limited (“Shell”) and the cross-appeal by the Minister of National Revenue (the “Minister”) require the Court to consider the proper income tax treatment of a sophisticated corporate financing arrangement. At the conclusion of the hearing, the Court allowed Shell’s appeal and dismissed the Minister’s cross-appeal, with reasons to follow for both decisions. These are those reasons.

I. Facts

In 1988, Shell required approximately $100 million in United States currency (“US$”) for general corporate purposes. To get the money it required at the lowest possible after-tax cost, Shell embarked upon a complex financing scheme that proceeded in two stages. First, Shell entered into debenture purchase agreements (the “Debenture Agreements”) with three foreign lenders, pursuant to which it borrowed approximately $150 million in New Zealand currency (“NZ$”) at the market rate of 15.4 percent annum. Shell was required to make payments of NZ$11.55 million to the foreign lenders on November 10 and May 10 of each year until 1993. The principal of NZ$150 million was to be returned to the foreign lenders on May 10, 1993.

Second, Shell entered into a forward exchange contract (the “Forward Exchange Contract”) with Sumitomo Bank Ltd. (“Sumitomo”), pursuant to which it used the NZ$150 million it had borrowed from the foreign lenders to purchase approximately US$100 million. That US$100 million was then used in Shell’s business. The Forward Exchange Contract between Shell and Sumitomo also allowed Shell to, (1) exchange a specified amount of US$ for NZ$1 1.55 million on each day that a semi-annual payment to the foreign lenders was due, and (2) to exchange another specified amount of US$ for NZ$150 million when the time came to repay the principal to the foreign lenders.

The exchange rates in the Forward Exchange Contract were established by reference to the forward (or “future”) exchange rates for NZ$ for the period of the loan, 1.e., how much it would cost to purchase NZ$ when Shell required it in the future. Because of the declining value of the NZ$ at the time, the forward value (in US$) of the NZ$150 million Shell was required to repay the foreign lenders in 1993 was expected to be less than the current (or “spot”) value (in US$) of the same NZ$150 million when Shell borrowed it in 1988. Shell accordingly expected to realize a foreign exchange gain when it closed out the Forward Exchange Contract and repaid the principal to the foreign lenders using the devalued NZ$.

Shell also knew that the difference between the spot exchange rate and the forward exchange rate as between two currencies precisely reflects the difference between their current interest rates over the period of the loan. The amount of the foreign exchange gain Shell expected to earn would therefore reflect the difference between the interest rates for the two currencies for the period of the Debenture Agreements. Accordingly, by agreeing to buy NZ$ in the future at the lower forward exchange rate, Shell not only was able to “hedge” its exposure to the market fluctuation of the NZ$, but was also able to effectively bring the rate of interest it was paying for the NZ$ down to approximately the rate of interest it would have had to pay for US$.

The Debenture Agreements and the Forward Exchange Contract all closed on May 10, 1988. Shell was only obligated to abide by the former if the latter also closed. While it seems that the foreign lenders received from Sumitomo the NZ$ that they paid to Shell, which in turn sold the same NZ$ back to Sumitomo in exchange for US$, Shell was not aware of the source of the foreign lenders’ funds until after Shell had committed itself to entering the Debenture Agreements. All of the contracts closed properly, and all the funds changed hands as planned.

The trial judge made a number of specific findings about the Debenture Agreements and the Forward Exchange Contract. He found, inter alia, that Shell’s decision to enter into these arrangements was based on its expectation that it would be able to deduct from its income the interest paid on the Debenture Agreements and that the foreign exchange gain would be taxed on capital account. Taxing the foreign exchange gain on capital account would be an advantage for Shell because, (1) only 75 percent of the gain would be taxable, rather than 100 percent as would be the case were it included on income account, and (2) the gain could be used to offset some of Shell’s existing capital losses. The trial judge further found that Shell would not have entered into the Debenture Agreements in the absence of the For- ward Exchange Contract, that none of the transactions was a sham, and that if Shell had simply borrowed US$ at a market rate of interest, it would have paid 9.1 percent per annum instead of the 15.4 percent per annum it had paid for the NZ$.

When computing its income for tax purposes for the years 1988 to 1993 inclusive, Shell relied on s. 20(1 )(c) of the Income Tax Act, R.S.C., 1985, c. 1 (5th Supp.), (the “Act”) and deducted the interest, calculated at the rate of 15.4 percent per annum, that it had paid to the foreign lenders under the Debenture Agreements. For its 1993 taxation year, the year in which the Forward Exchange Contract was closed out and the principal was repaid to the foreign lenders under the Debenture Agreements, Shell reported a capital gain of approximately US$21 million.

The Minister objected and issued formal reassessments for the 1992 and 1993 taxation years. By these reassessments, Shell was only permitted to deduct interest at the rate it would have paid had it borrowed US$, 1.e., 9.1 percent per annum over a five-year term, because, according to the Minister, it was only the US$ — not the NZ$ — that were directly used in its business. The claimed capital gain for the 1993 taxation year was also reassessed as being on income account.

The Tax Court of Canada allowed Shell’s appeal from the Minister’s reassessment. The Minister was then partly successful in his appeal to the Federal Court of Appeal, which held that Shell could only claim the limited interest rate deduction suggested by the Minister but could however claim the net foreign exchange gain on capital account. Shell now appeals to this Court the Federal Court of Appeal’s decision on the interest rate issue. The Minister cross-appeals the Federal Court of Appeal’s disposition of the capital gain issue.

The interveners are parties in another appeal before this Court: Canadian Pacific Limited v. Her Majesty The Queen, S.C.C., File No. 27163. Because of the similarities between that case and the one now before this Court, these parties were granted leave to intervene in this appeal.

II Statutory Provisions

Income Tax Act, R.S.C., 1985 c. 1, (5th Supp.)

9. (1) Subject to this Part, a taxpayer’s income for a taxation year from a business or property is the taxpayer’s profit from that business or property for the year.

(3) In this Act, “income from a property” does not include any capital gain from the disposition of that property and “loss from a property” does not include any capital loss from the disposition of that property.

20. (1) Notwithstanding paragraphs 18(!)(«), (b) and (/i), in computing a taxpayer’s income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto:

(c) an amount paid in the year or payable in respect of the year (depending on the method regularly followed by the taxpayer in computing the taxpayer’s income), pursuant to a legal obligation to pay interest on

(i) borrowed money used for the purpose of earning income from a business or property (other than borrowed money used to acquire property the income from which would be exempt or to acquire a life insurance policy),

or a reasonable amount in respect thereof, whichever is the lesser;

67. In computing income, no deduction shall be made in respect of an outlay or expense in respect of which any amount is otherwise deductible under this Act, except to the extent that the outlay or expense was reasonable in the circumstances.

Income Tax Act, S.C. 1970-71-72, c. 63

245. (1) In computing income for the purposes of this Act, no deduction may be made in respect of a disbursement or expense made or incurred in respect of a transaction or operation that, if allowed, would unduly or artificially reduce the income.

III. Judgments Below

A. Tax Court of Canada, [1997] 3 C.T.C. 2238 (T.C.C.)

Christie A.C.J.T.C. began by observing that it is open to a taxpayer to structure its affairs to secure tax benefits. Tax considerations are part of the commercial and economic reality within which business decisions are made. He also rejected (at para. 20) what he called the “foundation stone” of the Minister’s argument, namely that the effect of Shell’s arrangements was that the Debenture Agreements and the Forward Exchange Contract were merged into one for tax purposes. In the absence of clear judicial or statutory authority, Christie A.C.J.T.C. held that it was not open to him to recharacterize a taxpayer’s distinct legal relationships.

With respect to the deductibility of Shell’s interest payments to the foreign lenders, Christie A.C.J.T.C. held that the rate of 15.4 percent per annum was a market rate and, as such, was “reasonable” within the meaning of s. 20(l)(c)(i) of the Act. The fact that the NZ$ were immediately exchanged for US$ before being applied to general corporate purposes did not deprive the NZ$ of its character as borrowed money used for the purpose of earning income from a business. Shell was therefore entitled to deduct the interest at the rate of 15.4 percent per annum.

The Minister also relied on s. 67 and former s. 245(1) of the Act. Christie A.C.J.T.C. rejected the argument that s. 67 could operate to reduce the permissible rate of deductible interest when that rate had already been found to be reasonable within the meaning of s. 20(1)(c)(1). For the same reason, neither did he see any scope for the application of former s. 245(1), which addressed deductions that “unduly or artificially” reduced a taxpayer’s income. Even if s. 245(1) could operate to reduce a deduction otherwise permitted by the Act, he held that it did not apply here. Shell’s transactions were not contrary to the object and spirit of s. 20(l)(c)(i) and the evidence showed that they were in accordance with normal business practice.

With respect to the gain realized in 1993, Christie A.C.J.T.C. concluded that, generally, an agreement to borrow a specified amount of funds for a fixed period of five years for the purpose of earning income is to be regarded as a capital transaction. There was no reason to hold otherwise in this case. If there were two gains - one on the Debenture Agreements and one on the Forward Exchange Contract - he held that they should be treated similarly. Christie A.C.T.J.C. allowed Shell’s appeal from the Minister’s reassessment.

B. Federal Court of Appeal, [1998] 3 F.C. 64 (Fed. C.A.)

The Minister appealed to the Federal Court of Appeal. After reviewing the origins of s. 20( 1 )(c)(i) and its predecessor provisions, Linden J.A. concluded that Parliament intended “to restrict the deduction [of interest] to those amounts that were reasonable and which reflected the economic realities of the situation” (para. 31). Here, that amount was 9.1 percent per annum, the rate at which US$ were directly available to Shell.

Linden J.A. held that there were four elements of s. 20(1)(c)(i). To be deductible, (1) the amount must be paid or payable in the year in which it is deducted; (2) it must be paid pursuant to a legal obligation to pay interest on borrowed money; (3) the borrowed money must be used for the purpose of earning income from a business or property; and (4) the amount must be calculated at a reasonable rate. Shell’s attempted deduction satisfied only the first criterion.

Linden J.A. concluded that the second condition had not been met. Considering that he was not “constrained by contract theory” (para. 59) and that the important consideration was “not what the parties agree to, nor what their intent is” (para. 59), he held that the Debenture Agreements and the Forward Exchange Contract had to be considered together to determine whether the amounts Shell sought to deduct were actually “interest”. In his view, the real “interest” amounts could only be identified after reducing the putative interest payments by an amount equal to the foreign exchange gain created by the discounted forward rate on the NZ$, amortized over the term of the loan. On this approach, he concluded that Shell’s deductions were not entirely interest: that portion exceeding 9.1 percent per annum must have been a repayment of principal.

Neither had the third condition been met, held Linden J.A: “[l]ooking realistically at the substance of the situation, there was no use and purpose other than the avoidance of taxation for borrowing NZ$” (para. 60). This, he concluded, was not an eligible use. Because only the US$ were used to earn eligible income, s. 20( 1 )(c)(i) permitted only the deduction of interest calculated at the rate of 9.1 percent per annum.

Shell’s attempted deduction also failed to satisfy the fourth condition. While it was reasonable for the foreign lenders to charge 15.4 percent per annum on the loan of the NZ$, Linden J.A. held that it was not reasonable for Shell to pay that rate. The only money used for an eligible purpose was the US$, held Linden J.A., and the reasonableness of the deduction must be assessed on that basis: “Shell should be in the same position as a taxpayer who borrowed US$ directly. That interest rate was then 9.1%” (para. 63). In Linden J.A.’s view, this fourth criterion was a type of “anti-avoidance” tool that should be used to prevent a taxpayer from artificially reducing its tax payable. In his opinion, that was what had happened here.

Given his conclusion with respect to s. 20(l)(c)(i), Linden J.A. did not have to address s. 67 or s. 245(1).

Turning to whether the gain realized in 1993 was earned on income or capital account, Linden J.A. concluded that there were two gains. One gain was earned on the Forward Exchange Contract because the forward exchange rate set by the Forward Exchange Contract was lower than the spot rate of exchange for converting US$ into NZ$ in 1993. The second gain arose on the Debenture Agreements because the 1993 value of the NZ$150 million that Shell repaid to the foreign lenders was less than the value of the NZ$ it had borrowed in 1988. Linden J.A. held that Christie A.C.J.T.C. correctly concluded that the character of a foreign exchange gain is determined by the nature of the underlying transaction. Here, the underlying transactions - the Debenture Agreements and the Forward Exchange Contract - were capital in nature, and so therefore must be the gains. He noted that the Minister had indicated that adjustments would be made to the amount of the taxable foreign exchange gain to reflect his success on the interest rate issue.

Stone J.A. wrote concurring reasons, addressing only the Minister’s alternative argument that s. 245(1) applied to Shell’s transactions in the event that s. 20( 1 )(c)(i) did not reduce the effective rate of interest to 9.1% per annum. He rejected this submission, holding that the transactions were not contrary to the object and spirit of s. 20( 1 )(c)(i), that they were in accordance with normal business practice, and that they had a bona fide business purpose, namely the acquisition of capital for a legitimate business use.

IV. Issues

There are two main issues on Shell’s appeal. First, does s. 20( 1 )(c)(i) of the Act allow Shell to deduct from its income all of the semi-annual interest payments it made to the Foreign lenders under the Debenture Agreements? Second, if so, does either s. 67 or the former s. 245(1) of the Act apply to reduce the deduction to the amount that would have been paid if US$ had been borrowed directly?

The issue on the Minister’s cross-appeal is whether the approximately US$21 million foreign exchange net gain that Shell earned should be taxed as part of Shell’s income, or taxed as a capital gain.

V. Analysis

A. Does Section 20(l)(c)(i) Allow Shell to Deduct From Its Income All of the Payments It Made to the Foreign Lenders Under the Debenture Agreements?

1. How Should Section 20(l)(c)(i) Be Applied to this Case?

I propose to first outline how s. 20( 1 )(c)(i) seems to apply to this case, before turning to consider the objections made by the Minister and accepted by the Federal Court of Appeal.

Section 20( 1 )(c)(i) allows taxpayers to deduct from their income interest payments on borrowed money that is used for the purpose of earning income from a business or property. It is an exception to s. 9 and s. 18(1)(b), which would otherwise prohibit the deduction of amounts expended on account of capital, i.e., interest on borrowed funds used to produce income: Canada Safeway Ltd. v. Minister of National Revenue, [1957] S.C.R. 717 (S.C.C.) at pp. 722-23, per Kerwin C.J., and at p. 727, per Rand J.; Bronfman Trust v. R., [1987] 1 S.C.R. 32 (S.C.C.) at p. 45, per Dickson C.J. The provision has four elements: (1) the amount must be paid in the year or be payable in the year in which it is sought to be deducted; (2) the amount must be paid pursuant to a legal obligation to pay interest on borrowed money; (3) the borrowed money must be used for the purpose of earning non-exempt income from a business or property; and (4) the amount must be reasonable, as assessed by reference to the first three requirements.

The first element is clearly met. No one disputes that the amounts paid by Shell to the foreign lenders were actually paid during the years in which they were sought to be deducted.

The second element is also met. Shell had a legal obligation to make the semi-annual payments to the foreign lenders under the Debenture Agreements. Those semi-annual payments constituted “interest”, or “the return or consideration or compensation for the use or retention by one person of a sum of money, belonging to, in a colloquial sense, or owed to, another”: Saskatchewan (Attorney General) v. Canada (Attorney General), [1947]

S.C.R. 394 (S.C.C.), aff’d (1948), [1949] A.C. 110 (Canada P.C.). As between Shell and the foreign lenders, there is no indication that the semiannual payments were anything but consideration for the use, for five years, of the NZ$150 million that Shell had borrowed. It was not a synthesized US$ loan from the foreign lenders to Shell: Shell actually received the NZ$150 million from the foreign lenders under the Debenture Agreements and paid real interest in consideration for its use.

The third element — that the borrowed money is used for the purpose of earning non-exempt income from a business or property — has likewise been met. This element focuses not on the purpose of the borrowing per se, but rather on the taxpayer’s purpose in using the borrowed money. As Dickson C.J. stated in Bronfman Trust, supra, at p. 46, “the focus of the inquiry must be centered on the use to which the taxpayer put the borrowed funds”. Dickson C.J. further specified that it is the current use of the borrowed money that is relevant and that the provision generally “requires tracing the use of borrowed funds to a specific eligible use”: Bronfman Trust, supra, at p. 53. The deduction is therefore not available where the link between the borrowed money and an eligible use is only indirect. Interest is deductible only if there is a sufficiently direct link between the borrowed money and the current eligible use: Tennant v. R., [1996] 1 S.C.R. 305 (S.C.C.) at paras. 18-20, per lacobucci J. Furthermore, it does not necessarily matter if the borrowed funds are commingled with funds used for another purpose, provided that the borrowed funds can in fact be traced to a current eligible use.

Here, Shell borrowed NZ$150 million from the foreign lenders and immediately exchanged it for approximately US$100 million before applying it to its business. This exchange did not alter the basic character of the funds as “borrowed money”. Money is fungible. The US$100 million was simply the NZ$150 million transformed into a different currency which, although it changed its legal form and its relative value, did not change its substance. It remained money. The value it represented simply changed from being denominated in New Zealand currency to being denominated in United States currency. Viewed thus, it is apparent that all of the NZ$150 million that Shell borrowed from the foreign lenders was borrowed money currently and directly used for the purpose of producing income from Shell’s business. The direct link between the borrowed money and the activity calculated to produce income can hardly be compared to the indirect use at issue in Bronfman Trust, supra.

The mere fact that an exchange had to occur before usable money was produced is not particularly significant. Except where the borrower is a money trader, borrowed money can rarely itself produce income. It must always be exchanged for something, whether it be machinery or goods, which then produces income. The necessity of such an exchange does not mean that the eventual production of income is an indirect use of the borrowed money. If a direct link can be drawn between the borrowed money and an eligible use, the third criterion is satisfied. That is clearly the case here.

The fourth element - that the amount sought to be deducted must be the actual amount paid or “a reasonable amount in respect thereof’ - has not previously been the subject of comment by this Court. It is clear, however, from the structure of s. 20(1)(c), that the phrase refers to the entirety of s. 20( 1 )(c)(i). Therefore, the taxpayer is entitled to deduct the lesser of, (1) the actual amount paid or, (2) a reasonable amount in respect of “an amount paid ... pursuant to a legal obligation to pay interest on ... borrowed money used for the purpose of earning income from a business or property”. Here, the borrowed money that was used for the purpose of earning income was the NZ$150 million. At trial, Christie A.C.J.T.C. found that the market rate for a loan of NZ$ in 1988 for the five-year term specified in the Debenture Agreements was 15.4 percent per annum. That is the rate Shell paid. Where an interest rate is established in a market of lenders and borrowers acting at arm’s length from each other, it is generally a reasonable rate: Mohammad v. À. (1997), 97 D.T.C. 5503 (Fed. C.A.) at p. 5509, per Robertson J.A.; Irving Oil Ltd. v. R., [1991] 1 C.T.C. 350 (Fed. C.A.) at p. 359, per Mahoney J.A. The fourth criterion is accordingly satisfied.

On this analysis, Shell was entitled to deduct from its income all of its semi-annual payments of interest to the foreign lenders during the relevant taxation years.

2. The Minister's Objections

The Minister objects to this application of s. 20( 1 )(c)(i). He makes two principal arguments. First, he submits that because only the US$ were used for the purpose of earning income from a business, Shell is only entitled to deduct as “interest” those amounts relating to the US$. This amount, he argues, must be calculated by reference to the rate of 9.1 percent per annum, the rate applicable to a borrowing of US$ in 1988. Second, the Minister argues that the phrase “a reasonable amount in respect thereof’ in s. 20( 1 )(c)(i) must be interpreted as referring to a reasonable amount to pay for a loan of the US$ which were actually used to produce income. That, he again submits, must be calculated at the rate of 9.1 percent per annum. The Minister also makes a subsidiary argument that the borrowed funds for which interest was paid at a rate exceeding 9.1 percent per annum were actually being used to produce a capital gain, not eligible income from a business or property as required by s. 20(1)(c)(1). These arguments found favour with the Federal Court of Appeal. With respect, however, they cannot prevail when examined in light of the approach this Court has consistently taken when interpreting the Act in general and s. 20(1)(c)(i) in particular.

These arguments rest on the view that only the US$ were used to produce income from a business or property. As discussed above, that is incorrect. The fact that the NZ$ can be directly traced to an income-producing use in accordance both with the text of s. 20(1 )(c)(i) and with this Court’s decisions in Bronfman Trust, supra, and Tennant, supra, deprives these arguments of any foundation.

Furthermore, these submissions arise from a fundamental misapprehension of the scope of s. 20( 1 )(c)(i) and the principles against which it should be interpreted. Both the Minister and the Federal Court of Appeal seem to suggest that s. 20(1)(c)(1) invites a wide examination of what Linden J.A. referred to (at para. 44) as the “economic realities” of a taxpayer’s situation. Underlying this argument appears to be the view that taxpayers are somehow disentitled from relying on s. 20( 1 )(c)(i) if the structure of the transaction was determined by a desire to minimize the amount of tax payable.

This Court has repeatedly held that courts must be sensitive to the economic realities of a particular transaction, rather than being bound to what first appears to be its legal form: Bronfman Trust, supra, at pp. 52-53, per Dickson C.J.; Tennant, supra, at para. 26, per lacobucci J. But there are at least two caveats to this rule. First, this Court has never held that the economic realities of a situation can be used to recharacterize a taxpayer’s bona fide legal relationships. To the contrary, we have held that, absent a specific provision of the Act to the contrary or a finding that they are a sham, the taxpayer’s legal relationships must be respected in tax cases. Recharacterization is only permissible if the label attached by the taxpayer to the particular transaction does not properly reflect its actual legal effect: Continental Bank of Canada v. R., [1998] 2 S.C.R. 298 (S.C.C.) at para. 21, per Bas- tarache J.

Second, it is well established in this Court’s tax jurisprudence that a searching inquiry for either the “economic realities” of a particular transaction or the general object and spirit of the provision at issue can never supplant a court’s duty to apply an unambiguous provision of the Act to a taxpayer’s transaction. Where the provision at issue is clear and unambiguous,

its terms must simply be applied: Continental Bank of Canada, supra, at para. 51, per Bastarache J.; Tennant, supra, at para. 16, per lacobucci J.; Antosko v. Minister of National Revenue, [1994] 2 S.C.R. 312 (S.C.C.) at pp. 326-27 and 330, per lacobucci J.; Friesen v. R., [1995] 3 S.C.R. 103 (S.C.C.) at para. 11, per Major J; Canada Trustco Mortgage Corp. v. Port O'Call Hotel Inc., [1996] 1 S.C.R. 963 (S.C.C.) at para. 15, per Cory J.

It is my respectful view that by paying insufficient attention to these very important principles, the Minister and the Federal Court of Appeal fell into error. First, the Federal Court of Appeal effectively recharacterized for tax purposes Shell’s legal relationship with the foreign lenders. Indeed, Linden J.A. held that, when the Forward Exchange Contract between Shell and Sumitomo was considered alongside the Debenture Agreements between Shell and the foreign lenders, “[t]he higher interest rate coupled with the discounted forward rate created a blended payment of interest and principal” (para. 58). With respect, this ignores the actual relationship between Shell and the foreign lenders, a relationship to which Sumitomo was not a party. As between Shell and the foreign lenders, the semi-annual payments were entirely “interest”, paid in consideration for the loan of NZ$150 million. That characterization cannot be changed by whatever other legal relationships Shell may have concluded with third parties, or indeed by anything that Shell did with the borrowed funds after receiving them from the foreign lenders.

It is no doubt true that Shell was able to recoup its higher interest expenses, paid to the foreign lenders, by agreeing with Sumitomo to purchase NZ$ in the future at a discount. This arrangement allowed it to earn a foreign exchange gain and, when the transactions were considered together, to equalize the interest rate in the Debenture Agreements to the prevailing market rate for a loan of US$. Yet, as has been demonstrated above, the words of s. 20(1 )(c)(i) are very clear. A taxpayer is entitled to deduct a reasonable amount of interest paid on borrowed money used for the purpose of earning eligible income from a business or property. Shell’s legal relationship with the foreign lenders comes within those criteria and, as such, Shell is entitled to the benefit of s. 20(1 )(c)(i).

Second, it is my respectful view that the Federal Court of Appeal’s misplaced reliance on “economic realities” caused it to stray from the express terms of s. 20( 1 )(c)(i) and supplement the provision with extraneous policy concerns that were said to form part of its purpose. The Act is a complex statute through which Parliament seeks to balance a myriad of principles. This Court has consistently held that courts must therefore be cautious before finding within the clear provisions of the Act an unexpressed legislative intention: Canderel Ltd. v. R., [1998] 1 S.C.R. 147 (S.C.C.) at para. 41, per lacobucci J.; Royal Bank v. Sparrow Electric Corp., [1997] 1 S.C.R. 411 (S.C.C.) at para. 112, per lacobucci J.; Antosko, supra, at p. 328, per lacobucci J. Finding unexpressed legislative intentions under the guise of purposive interpretation runs the risk of upsetting the balance Parliament has attempted to strike in the Act.

Although the terms of s. 20( 1 )(c)(i) are clear, the Federal Court of Appeal seems to have discerned in the Act an intention that courts, to be fair to less sophisticated taxpayers, should be alert to preventing taxpayers from using complex transactions designed to minimize their tax liability. It was said that courts should somehow look through transactions and impose tax according to their true economic and commercial effects. There are some obiter statements in some cases that may be said to support this view: Bronfman Trust, supra, at p. 53, per Dickson C.J.; Stubart Investments Ltd. v. R., [1984] 1 S.C.R. 536 (S.C.C.) at p. 576, per Estey J.

However, this Court has made it clear in more recent decisions that, absent a specific provision to the contrary, it is not the courts’ role to prevent taxpayers from relying on the sophisticated structure of their transactions, arranged in such a way that the particular provisions of the Act are met, on the basis that it would be inequitable to those taxpayers who have not chosen to structure their transactions that way. This issue was specifically addressed by this Court in Duha Printers (Western) Ltd. v. R., [1998] 1 S.C.R. 795 (S.C.C.) at para. 88, per lacobucci J. See also Neuman v. Minister of National Revenue, [1998] 1 S.C.R. 770 (S.C.C.) at para. 63, per lacobucci J. The courts’ role is to interpret and apply the Act as it was adopted by Parliament. Obiter statements in earlier cases that might be said to support a broader and less certain interpretive principle have therefore been overtaken by our developing tax jurisprudence. Unless the Act provides otherwise, a taxpayer is entitled to be taxed based on what it actually did, not based on what it could have done, and certainly not based on what a less sophisticated taxpayer might have done.

Inquiring into the “economic realities” of a particular situation, instead of simply applying clear and unambiguous provisions of the Act to the taxpayer’s legal transactions, has an unfortunate practical effect. This approach wrongly invites a rule that where there are two ways to structure a transaction with the same economic effect, the court must have regard only to the one without tax advantages. With respect, this approach fails to give appropriate weight to the jurisprudence of this Court providing that, in the absence of a specific statutory bar to the contrary, taxpayers are entitled to structure their affairs in a manner that reduces the tax payable: Stubart, supra, at p. 540, per Wilson J., and at p. 557, per Estey J.; Hickman Motors Ltd. v. R., [1997] 2 S.C.R. 336 (S.C.C.) at para. 8, per McLachlin J.; Duha, supra, at para. 88, per lacobucci J.; Neuman, supra, at para. 63, per lacobucci J. An unrestricted application of an “economic effects” approach does indirectly what this Court has consistently held Parliament did not intend the Act to do directly.

The Federal Court of Appeal’s overriding concern with tax avoidance not only coloured its general approach to this case, but may also have led it to misread the clear and unambiguous terms of s. 20(1 )(c)(i) itself. In his reasons, Linden J.A. emphasized that Shell only decided to borrow NZ$ from the foreign lenders because it sought to take advantage of the higher interest rate applicable to NZ$. Yet, as Dickson C.J. made clear in Bronfman Trust, supra, at p. 46, the reason for a particular method of borrowing is irrelevant to a proper consideration of s. 20( 1 )(c)(i). The issue is the use to which the borrowed funds are put. It is irrelevant why the borrowing arrangement was structured the way that it was or, indeed, why the funds were borrowed at all.

The fact that Shell structured its transactions so that it could take advantage of the various provisions of the Act is therefore of no moment. It was fully entitled to do so. Shell borrowed NZ$ for the purpose of using them to produce eligible income from a business or property and is accordingly entitled to the deduction provided by s. 20( 1 )(c)(i).

B. Does Section 67 or Former Section 245(1) Apply to this Case?

If s. 20(1 )(c)(i) does not apply to restrict Shell to deducting interest at the rate of 9.1 percent per annum, the Minister argues that s. 67 and the former s. 245(1) apply to reduce the deduction to the amount that would have been paid if US$ had been borrowed directly. However, neither provision supports the Minister’s position.

1. Section 67

Section 67 of the Act provides that:

67. In computing income, no deduction shall be made in respect of an outlay or expense in respect of which any amount is otherwise deductible under this Act, except to the extent that the outlay or expense was reasonable in the circumstances.

The Federal Court of Appeal did not address s. 67 and Shell made no submissions to this Court with regard to it. The Minister submits that the only amount “reasonable in the circumstances” is the amount that Shell would have had to pay if it had borrowed US$ directly. The argument seems to be the same one that was made with respect to s. 20( 1 )(c)(i) 1.e., it is suggested that the only money used for the purpose of producing income was the US$. I note that the Minister did not press this point in argument before the Court.

Having already held that the NZ$ actually were used for the purpose of earning eligible income, it follows that I do not accept the premise of the Minister’s argument. Furthermore, it seems to me that Parliament intended s. 67 to apply primarily to those deductions claimed under the provisions of the Act that do not have their own internal limiting clauses: see also Peter

W. Hogg and Joanne E. Magee, Principles of Canadian Income Tax Law, (2nd ed. 1997), at pp. 244-45. A common example is the case where a taxpayer seeks to pay unreasonably high rents or salaries to non-arm’s-length persons. Another example might be unreasonably high business travelling expenses. Where the applicable provision has its own internal reference to “reasonableness”, as does s. 20( 1 )(c)(i), s. 67 could not apply without distorting the plain meaning of the more specific provision. Indeed, if a deduction is “reasonable” within the meaning of s. 20( 1 )(c)(i), I have difficulty seeing how it would not also be “reasonable” within the meaning of s. 67.

2. Section 245( 1)

The Minister also relies on the former s. 245(1). Section 245(1) read as follows:

245. (1) In computing income for the purposes of this Act, no deduction may be made in respect of a disbursement or expense made or incurred in respect of a transaction or operation that, if allowed, would unduly or artificially reduce the income.

This provision has been repealed and replaced by a new “General AntiAvoidance Rule” effective September 13, 1988: S.C. 1988, c. 55, s. 185. Because the Debenture Agreements and the Forward Exchange Contract were entered into prior to that time, however, it is only the former s. 245(1) that applies to this case.

The Minister does not say that Shell “artificially” reduced its income. Rather, he claims that allowing Shell to deduct interest expenses at the NZ$ rate of 15.4 percent per annum would “unduly” reduce its income. This argument again rests on the submission that it was the US$ that were used for producing eligible income, not the NZ$. Because I reject the Minister’s argument on that point, it follows that I cannot accept his related submissions on s. 245(1).

In a series of recent cases, the Federal Court of Appeal has considered the proper meaning to be given to s. 245(1): Fording Coal Ltd. v. R. (1995), [1996] 1 F.C. 518 (Fed. C.A.), leave to appeal denied, [1996] 3 S.C.R. viii (S.C.C.); Central Supply Co. (1972) Ltd. v. R., [1997] 3 F.C. 674 (Fed. C.A.), leave to appeal denied, [1997] 3 S.C.R. vii (S.C.C.). In Central Supply Co., supra, at p. 691, Linden J.A. summarized the three factors to be answered under the recommended approach to s. 245(1): (1) whether the deduction sought is contrary to the object and spirit of the provision in the Act, (2) whether the deduction is based on a transaction which is not in accordance with normal business practice, and (3) whether there was a bona fide business purpose for the transaction. He observed that these three factors apply even where the deduction is otherwise permitted by a specific provision of the Act.

I note that the Federal Court of Appeal has not always taken this approach to the former anti-avoidance provisions of the Act: see Mara Properties Ltd. v. R., [1995] 2 F.C. 433 (Fed. C.A.) at pp. 437-38, per Marceau J.A., and at p. 452, per McDonald J.A., appeal allowed on other grounds, [1996] 2 S.C.R. 161 (S.C.C.); Fording Coal, supra, at pp. 541-44, per McDonald J.A. (dissenting); Central Supply, at pp. 712-16, per McDonald J.A. (dissenting); Nova Corp. of Alberta v. R. (1997), 97 D.T.C. 5229 (Fed. C.A.) at p. 5236, per McDonald J.A. Indeed, particularly with respect to its emphasis on whether there was a “bona fide purpose” for the transaction, the approach adopted in Fording Coal Ltd., supra, and Central Supply Co., supra, appears to run against the grain of some of the Federal Court of Appeal’s earlier interpretations of this provision and its predecessors: Produits L.D.G. Products Inc. v. Minister of National Revenue (1976), 76 D.T.C. 6344 (Fed. C.A.) at p. 6349, per Pratte J.A.; R. v. Alberta & Southern Gas Co. (1977), [1978] 1 F.C. 454 (Fed. C.A.) at pp. 462-63, per Jack- ett C.J.; Irving Oil Ltd., supra, at p. 360, per Mahoney J.A. See also, Stubart Investments Ltd., supra, at pp. 569-70, per Estey J.

The Minister submits that the factors developed in Fording Coal Ltd., supra, and Central Supply Co., supra, apply only when it is claimed that the deductions are “artificial”, not when they are said to be “undue”, as in the case on appeal. Although the matter is not entirely free from doubt, a review of the Federal Court of Appeal’s reasons in those cases does not support such a constrained interpretation of the test. Indeed, it was certainly the understanding of Stone J.A. in the Federal Court of Appeal, the only member of the panel who expressed an opinion on this point, that those factors apply to s. 245(1) in its entirety. I agree that this is what the Federal Court of Appeal likely intended in Fording Coal Ltd., supra, and Central Supply Co., supra. I hasten to add that I should not be taken as necessarily agreeing that the three factors are the appropriate interpretive tools with which to understand s. 245(1). Because even the broadest interpretation of s. 245(1) does not apply to limit Shell’s deductions, however, it is not necessary in this appeal for this Court to determine conclusively the proper interpretation to be given to s. 245(1).

Applying the factors set forth by the Federal Court of Appeal suggests the following analysis in this case. First, deducting the interest paid to the foreign lenders at the rate of 15.4 percent per annum is not contrary to the object and spirit of s. 20( 1 )(c)(i). In Bronfman Trust, supra, Dickson C.J., held at p. 45, that the purpose of this provision is “to encourage the accumulation of capital which would produce taxable income”; see also, Tennant , supra, at para. 16, per lacobucci J. Allowing Shell to deduct its interest payments at the actual rate that was paid to the foreign lenders in exchange for the NZ$150 million that was then used for the purpose of producing income is not contrary to the object and spirit of s. 20( 1 )(c)(i). To the contrary, it fulfills its purpose.

Second, the deductions were based on transactions that were in accordance with normal business practice. At trial, Christie A.C.J.T.C. accepted that this was so, noting in addition that the “fact that business transactions may be regarded as convoluted does not, of course, mean that they are abnormal” (para. 31). Stone J.A. agreed, holding that “[i]n choosing to borrow the funds in NZ$ rather than US$ the respondent took into account the overall tax impact of the transaction, and this is a common business concern” (para. 5). Before this Court, evidence was adduced demonstrating that this form of international interest rate arbitrage is commonly done, even by non- taxable governmental entities. When coupled with the fact that the Debenture Agreements provided Shell with money that satisfied its need for capital, the conclusion that they reflected normal business practice is unavoidable.

The third factor to consider, according to the Federal Court of Appeal, is whether Shell entered the Debenture Agreements for a bona fide business purpose. Certainly, Shell structured its transactions this way because it wanted to borrow the necessary funds at the lowest possible after-tax cost. The Minister contends that this was not a bona fide business purpose. Even if it could be said that acquiring funds at the lowest possible after-tax cost is not a bona fide business purpose - a proposition on which I need express no opinion - another purpose clearly lay in Shell’s need to borrow the NZ$ as part of its plan to acquire funds for business purposes. Therefore, even granting the Minister’s point for the sake of argument, there was “a bona fide business purpose” for the Debenture Agreements that gave rise to the deductions in issue. The third criterion is satisfied.

On the broad test for the former s. 245(1) developed by the Federal Court of Appeal, Shell’s decision to deduct its interest payments to the foreign lenders at the rate of 15.4 percent cannot be impugned. It is accordingly unnecessary to decide whether the Federal Court of Appeal has correctly ascertained Parliament’s intention in passing the provision, which, it must be repeated, has now been repealed and replaced by a new anti-avoidance tool.

For these reasons, this Court allowed Shell’s appeal and held that the s. 20( 1 )(c)(i) allowed it to deduct the entirety of the interest payments made by it to the Foreign lenders under the Debenture Agreements.

C. Is Shell’s Net Foreign Exchange Gain Taxable as Income or as a Capital Gain?

The issue on the Minister’s cross-appeal is whether the approximately US$21 million net foreign exchange gain that Shell realized through the Debenture Agreements and the Forward Exchange Contract should be included in its income for tax purposes, or whether it should be taxed as a capital gain. In the event that he was unsuccessful in arguing that the amount of Shell’s interest payments exceeding 9.1 percent per annum should be disallowed, the Minister argued in the alternative that the net foreign exchange gain should be included in Shell’s income. The Court dismissed the Minister’s cross-appeal, holding that the net foreign exchange gain should be taxed on capital account.

Because transactions must be reported in CDN$ for income tax purposes, foreign exchange gains or losses may arise when a business engages in transactions denominated in a foreign currency. Although they generally agree that, in this case, Shell earned a net foreign exchange gain through the Debenture Agreements and the Forward Exchange Contract, the Minister and Shell disagree on how best to describe it. The Minister simply contends that, in 1988, Shell borrowed the equivalent of US$100 million from the foreign lenders but, in 1993, because of the Forward Exchange Contract, was able to repay the loan using only US$79.5 million. This, it says, gave rise to a gain of approximately US$21 million, which of course must be converted into CDN$ for tax purposes

Shell, on the other hand, submits that there were two gains, which together yield the same net result as the Minister’s approach. One gain arose on the Debenture Agreements because, while Shell borrowed the equivalent of US$100 million in 1988, it took the equivalent of only US$81.5 million to repay it in 1993 (assessed by reference to the market rate for NZ$ in 1993). However, it did not actually cost Shell US$81.5 million to repay the principal to the foreign lenders because it had hedged its risk through the Forward Exchange Contract. A second gain therefore arose on the Forward Exchange Contract in 1993 because, while it would have cost US$81.5 million to purchase NZ$150 million at the market rate, Shell was able to rely on the discounted rate agreed upon in 1993 to reduce its own cost of the NZ$150 million to US$79.5 million. Thus, it claims it earned a gain on the Forward Exchange Contract of US$1.98 million. Combining the two gains leads to a net foreign exchange gain of approximately US$21 million, which again would have to be converted into CDN$ for tax purposes.

At trial, Christie A.C.J.T.C. held that it did not matter whether there were one or two gains because, even if there were two, both should be taxed on the capital account. For the Federal Court of Appeal, Linden J.A. held that there were two gains. Indeed, it seems to me that Shell is correct, i.e, that there were two gains arising from two transactions, which only created a net gain of approximately US$21 million when combined: see Stephen S. Ruby, “Recent Financing Techniques”, in Report of Proceedings of the Forty-First Tax Conference (1990), at pp. 27.3 to 27.6. In light of the prevailing market rate for NZ$ in 1993, one gain arose on the repayment of the NZ$150 million to the foreign lenders under the Debenture Agreements, and a smaller gain arose on the closing out of the Forward Exchange Contract with Sumitomo. The net result is the same as that yielded by the Minister’s suggested interpretation, but this view recognizes that Shell entered into two distinct transactions with two separate arm’s-length parties, which in turn gave rise to two foreign exchange gains.

Parenthetically, I note that there may be another way to interpret the closing out of the Forward Exchange Contract: Ruby, supra, at p. 27.12: David G. Broadhurst, “Income Tax Treatment of Foreign Exchange Forward Contracts, Swaps, and Other Hedging Transactions”, in Report of Proceedings of the Forty-First Tax Conference (1990), 26:1. Shell’s approach requires one to view this transaction as a disposition of US$ to Sumitomo in exchange for NZ$150 million. Any foreign exchange gain or loss is then calculated by comparing the rate established in the Forward Exchange Contract with the spot market rate for NZ$ in 1993. However, it is also possible to view the transaction as an acquisition of NZ$150 million for US$79.5 million. That purchase price — calculated according to the exchange rate established in the Forward Exchange Contract — would constitute Shell’s cost base for the NZ$150 million. When Shell used that NZ$150 million to repay the foreign lenders under the Debenture Agreements, Shell’s cost base for those funds could then be assessed against their spot market value at the time of repayment to determine whether Shell had realized a foreign exchange gain or loss on the Forward Exchange Contract. This would be in addition to any foreign exchange gain or loss Shell would earn on the repayment of the principal to the foreign lenders under the Debenture Agreements.

Because Shell immediately used the NZ$150 million from Sumitomo to discharge its obligations to the foreign lenders, however, the spot market rate for NZ$ and the amount of Shell’s gain on the Forward Exchange Contract is the same regardless of which approach is taken. It follows that the amount of the foreign exchange gain is also the same. It is therefore unnecessary on this appeal to decide which interpretation of the transaction is preferable.

The issue here is whether the foreign exchange gains were received by Shell on income account, in which case they are taxable in full, or whether they were received on capital account, in which case only three-quarters would be taxable. The characterization of a foreign exchange gain or loss generally follows the characterization of the underlying transaction: Minister of National Revenue v. Tip Top Tailors Ltd., [1957] S.C.R. 703 (S.C.C.) at p. 707, per Locke J., and at p. 712, per Rand J.; Alberta Gas Trunk Line Co. v. Minister of National Revenue (1971), [1972] S.C.R. 498 (S.C.C.) at p. 505, per Martland J.; Columbia Records of Canada Ltd. v. Minister of National Revenue, [1971] C.T.C. 839 (Fed. T.D.) at p. 845, per Gibson J.; Hogg and Magee, supra, at p. 344. Thus, if the underlying transaction was entered into for the purpose of acquiring funds to be used for capital pur- poses, any foreign exchange gain or loss in respect of that transaction will also be on capital account.

The purpose of the Debenture Agreements was to provide Shell with working capital for a five year term. It was a capital debt obligation: see generally Beauchamp (Inspector of Taxes) v. F.W. Woolworth pic, [1989] B.T.C. 233 (Eng. H.L.) at p. 237, per Lord Templeman; Columbia Records of Canada Ltd., supra, at p. 845, per Gibson J. Therefore, the foreign exchange gain arising from the fact that the value of the NZ$150 million that Shell returned to the foreign lenders in 1993 was less than the value of the NZ$150 million that Shell borrowed in 1988 was also received on capital account.

Whether a foreign exchange gain arising from a hedging contract should be characterized as being on income or capital account depends on the characterization of the debt obligation to which the hedge relates. As noted, Shell entered into the Forward Exchange Contract in order to hedge with US$ the market risk on the Debenture Agreements, which were denominated in NZ$. Indeed, Shell would not have entered into the Debenture Agreements in the absence of the Forward Exchange Contract. The gain on the Debenture Agreements was characterized as being earned on capital account and so therefore should the gain on the Forward Exchange Contract. Both gains were earned on capital account and three-quarters of them are taxable when realized.

Against these conclusions, the Minister argues that the income nature of the net foreign exchange gain is illustrated by the fact that Shell amortized it over the term of the Debenture Agreements for its non-tax financial accounting; that the net gain was related to the current payment of interest, which is an income expense pursuant to s. 20( 1 )(c)(i); that Shell was acting like a trader; and that the net gain did not arise fortuitously but rather was the result of a carefully executed plan.

To a large extent, the Minister’s submissions reflect his consistent view that there was a single gain arising from a synthesized transaction through which Shell was able to repay a loan of US$100 million with only US$79.5 million. Yet it is significant that there were actually two gains, arising from distinct transactions with separate arms-length parties, which only together yielded a net foreign exchange gain of US$21 million. The Minister does not make this distinction so, once again, I cannot accept the premise of his argument. Nor are the Minister’s other arguments persuasive.

First, the manner in which Shell recorded the net foreign exchange gain for its non-tax financial accounting is not determinative of the proper tax treatment. This Court has frequently held that accounting practices, by themselves, do not establish rules of income tax law: Canderel Ltd. , supra, at paras. 32-37, per lacobucci J. At any rate, non-tax financial accounting is generally designed to reflect the overall economic position of the entire corporation. Section 20( 1 )(c)(i) of the Act, in contrast, applies to the tax treatment of specific transactions. It therefore should not be surprising that the same transaction may properly be assessed differently for different purposes: see generally Friedberg v. R., [1993] 4 S.C.R. 285 (S.C.C.) at p. 286, per lacobucci J.

Second, the mere fact that the gains are related to the interest expenses incurred under the Debenture Agreements, which s. 20( 1 )(c)(i) allows Shell to deduct from its income, does not mean that the net foreign exchange gain should also be considered on income account. The Minister bases this argument on this Court’s decision in Ikea Ltd. v. R., [1998] 1 S.C.R. 196 (S.C.C.), where a tenant-inducement payment was held to be so directly related to the taxpayer’s rental payments that it should also be considered on income account. However, Ikea Ltd. does not assist the Minister. Shell did not receive any payment from either the Foreign lenders or Sumitomo to reimburse it for any expense it had paid. Furthermore, it is important to underline that interest expenses on money used to produce income from a business or property are only deemed by s. 20(l)(c)(i) to be current expenses and, in the absence of that provision, would be considered to be capital expenditures: Canada Safeway Ltd. Rand J., at p. 727. This Court was not invited on this appeal to revisit this characterization of such interest expenses: they therefore remain capital expenses which s. 20(1)(c)(i) deems to be deductible from Shell’s gross income notwithstanding the general prohibition of such capital deductions in s. 18(1). Accordingly, even if the general analysis in Ikea Ltd. applied to this case, it would tend to support the conclusion that the gains should be treated as being on capital account.

Third, the Minister’s argument that Shell was acting like a trader in borrowing NZ$ through the Debenture Agreements and exchanging them for US$ through the Forward Exchange Contract cannot succeed. Shell was acquiring money to use in its business. That was the purpose of the Debenture Agreements and the Debenture Agreements prompted the need for the Forward Exchange Contract. In no sense was Shell engaged in an “adventure in the nature of trade”.

Fourth, it is not particularly relevant that the net foreign exchange gain did not arise fortuitously but rather arose as a result of Shell’s deliberate contractual obligations. As noted, the proper tax treatment of a foreign exchange gain on both the initial borrowing and any related hedge transaction is to be assessed in light of the characterization of the underlying debt obligation. Transactions giving rise to debt obligations obviously do not have to be speculative to be capital in nature. It follows that foreign exchange gains do not have to arise from speculative transactions in order to be taxed as capital gains. In this case, for example, the underlying debt obligation recorded in the Debenture Agreements was entered into for the purpose of raising funds for use in Shell’s business. Neither it nor the related hedge transaction lose that characteristic simply because they were deliberate and organized.

For these reasons, the Court dismissed the Minister’s cross-appeal and held that the net foreign exchange gain realized by Shell upon the repayment of the NZ$150 million to the foreign lenders and the closing out of the Forward Exchange Contract was received on capital account.

VII. Conclusion

At the conclusion of the hearing of this appeal, the Court allowed Shell’s appeal and dismissed the Minister’s cross-appeal. The matter is therefore referred back to the Minister of National Revenue for reconsideration and reassessment in accordance with the judgment of the Tax Court of Canada. Shell shall have its costs in this Court and in the courts below.

Appeal allowed; cross-appeal dismissed.