Citation: 2008TCC17
Date: 20080130
Dockets: 2000-2049(IT)G, 2000-2026(IT)G,
2000-2039(IT)G, 2000-2044(IT)G, 2000-2045(IT)G,
2000-2056(IT)G, 2000-2069(IT)G, 2000-1189(IT)G
BETWEEN:
YVES BEAUDRY, JAMES BULLOCK,
CHRISTOPHER HERTEN-GREAVEN, RAPHAËL EVANSON,
OLEG ROMAR, MARTIN TYLER, DAVID ELKINS,
JAMES W. McCLINTOCK, EXECUTOR OF THE ESTATE
OF JOHN P. McCLINTOCK,
Appellants,
and
HER MAJESTY THE QUEEN,
Respondent.
[OFFICIAL ENGLISH TRANSLATION]
REASONS FOR JUDGMENT
Angers J.
[1] These appeals, which
were heard on common evidence, are from assessments under the Income Tax Act
("the Act"), whereby the Minister of National Revenue
("the Minister") disallowed business losses which had been
claimed by the Appellants in respect of their interests in the CMRA and/or CMRA 2
partnerships, and losses from one or both of those partnerships carried over by
certain appellants. The taxation years in issue are those from 1985 to
1990. Some of the Appellants also claimed deductions in respect of
carrying charges for one or both of the partnerships (as the case may be), and
the Minister disallowed those deductions.
[2] The issues, stated in
general terms, are as follows. To what deductions are the Appellants entitled,
in computing their income for the 1985 and 1986 taxation years, for losses
related to the CMRA and CMRA 2 partnerships? Are those for whom the
situation arises entitled, in computing their taxable income for
subsequent years, to a deduction with respect to a carry-over of non‑capital
losses from one or both partnerships, and to a deduction for carrying charges related
to the acquisition of shares in the CMRA and CMRA 2 partnerships?
[3] In the 1985 and
1986 taxation years, two partnerships, Canadian Medical Research Associates (CMRA)
and Canadian Medical Research Associates #2 (CMRA 2), were formed under the
laws of Ontario for the purpose of engaging, on their own account, in various
scientific research activities in the field of monoclonal antibodies.
CMRA
[4] CMRA was formed on July 16, 1985, by Corporation
Planagex Ltée (Planagex) and Investmed R.B. Inc. (Investmed). Both of
these firms of financial and tax advisors were controlled by CMRA's promoters,
namely the Appellants Oleg Romar and Yves Beaudry. The CMRA
partnership contract refers to an issue price of $1.00 per partnership share.
Under the terms of clause 4.2 of that contract, 24.528% of this price was
payable in Canadian funds upon the issuance or acquisition of shares, and 75.472%
took the form of a promissory note, payable in four equal annual
instalments commencing in the seventh year and ending in the tenth year after
the issuance of the shares. The four annual instalments were payable in
Brazilian funds, and the amount, payable in cruzeiros, was fixed at the exchange
rate in effect on the date of issuance of the partnership shares, that is to
say, the rate in effect when the shares were issued in 1985. Simple
interest at a rate of 11.5% was payable with each of the four annual
instalments.
[5] In the course of
its fiscal year which ended December 31, 1985, CMRA received C$18,199,908 in
total from its members. It also received from its members promissory notes for
a total of 369,199,023,074 Brazilian cruzeiros, payable from the seventh to the
tenth year following their issuance and bearing interest at a rate of 11.5%. During
the same fiscal year, CMRA paid Investmed C$4,199,750, which is 23.08% of the amount
in Canadian funds that CMRA received from its members as subscription,
administration and other fees.
CMRA 2
[6] The CMRA 2
partnership was formed on February 25, 1986, also under the laws of Ontario, by the same promoters
as those who had formed CMRA. The partnership contract specifies an issue price
of $1.00 per share, and, under clause 4.2 of the contract, the price of
each share was payable in the same manner as with CMRA, that is: 24.528% in
Canadian funds, and the balance, 75.472%, in the form of promissory notes, each
of which was payable, in Brazilian funds, in four equal annual instalments
commencing in the seventh year and ending in the tenth year following the
issuance of the partnership shares, and the amount, payable in cruzeiros, was
fixed at the exchange rate in effect on the date of issue of the shares in 1986.
Simple interest at a rate of 11% was payable with each of the four annual
instalments.
[7] CMRA 2's fiscal year
ended on December 31, 1986. In the course of that year, CMRA 2 received a total
of $19,050,413 in Canadian funds from its members. It received from them
as well 612,358,624 cruzeiros worth of promissory notes payable 7‑10 years
later with interest at a rate of 11%. CMRA 2 paid Techmed 23.08% of the Canadian funds received,
which amounted to $4,396,010.
[8] During their
respective fiscal years, both partnerships entered into scientific research and
experimental development (SR&ED) contracts with Coral Sociedade Brasilieira
De Pesquisas & Desenvolvimento ("Coral"), a corporation
controlled by Texas
businessman Allen F. Campbell through a Dutch company that he controlled.
The object was to have Coral set up and direct research activities at its
laboratory in Cambridge, England, and at another laboratory in Brazil.
[9] Thus, the funds
invested in CMRA and CMRA 2 were to be used for Coral's research. CMRA's contract
was entered into on July 16, 1985, and CMRA 2's contract was entered into on February 25, 1986.
CMRA's contract
[10] CMRA's contract
provided that Coral was to conduct research in the field of monoclonal
antibodies that was to result in 57 products, each consisting of a conjugate of
a murine monoclonal antibody and an enzyme that combine specifically in either
an immunological or immunochemical manner with a designated antigen. Coral was
to put forth its best efforts to complete the research work by
December 31, 1985. The price per product was 7,990,867,500
cruzeiros, and the total price for the 57 products was 455,479,447,500 cruzeiros.
The price, according to Schedule B to the contract, was payable in
cruzeiros and was split into two components: 20% in cash, payable in cruzeiros upon
completion of the work in 1985, and 80% consisting of four annual
instalments payable in cruzeiros commencing seven years after the end of the
work, with simple interest at 11.5%. The exchange rate applicable to
the payments under the contract was the rate in effect on the date that the contract
was signed.
[11] The contract between
CMRA and Coral also contained a clause providing for a possible reduction of
the number of products that would have to be produced and, in February 1986,
the number of products was indeed reduced, from 57 to 40, and the contract
price was adjusted accordingly.
[12] In the course of its
fiscal year 1985, CMRA paid Coral C$350,000 for each product, that is to say, C$14,000,158
in total, by cheque issued to Coral and transferred to Coral's Canadian bank
account. During the same fiscal year, CMRA issued 18 notes to Coral, denominated
in Brazilian currency, in connection with the 40 Coral projects. Based on
the exchange rates in effect at the time of the transactions between CMRA and
Coral in 1985, the Canadian-dollar equivalent of the principal amount of 369,199,023,074
cruzeiros was C$56,000,623, which amounts to C$1,400,000 for each of the 40
projects.
[13] In its financial
statements for the period from July 16 to December 31, 1985, CMRA entered
an expense of C$70,000,781 with respect to the contract signed with Coral.
CMRA relied not only on the C$14,000,158 in cash payments to Coral, but also on
the principal amount of the term notes denominated in Brazilian currency and signed
by CMRA in favour of Coral, in the amount of 369,199,023,074 cruzeiros, which
it converted into C$56,000,623 based on the exchange rate in effect on the date
of the transaction with Coral.
[14] There was no
inflation adjustment and no monetary or exchange‑rate adjustment with
respect to the 18 term notes denominated in Brazilian currency, signed by CMRA
in favour of Coral. Investmed specified that, with regard to the amounts that CMRA
owed Coral, Coral had agreed to waive joint and several liability, to divide
its claims, and to limit its remedy against each partner to the amount that the
partner owed the partnership.
[15] On March 7, 1986,
trustees Ernst Nigg and Christian Rusck notified CMRA that the 18 notes in Brazilian
currency issued to Coral had been assigned to Medical Research Trust (MRT). It
should be mentioned that Coral and MRT made no demand for payment on the 18
term notes, and in fact CMRA and its members did not pay anything on those 18 notes.
[16] On the same date
that the contract between CMRA and Coral was signed, the parties entered into a
hedge agreement intended to protect CMRA and its members in the event that Brazil's currency should
appreciate. CMRA paid C$1.00 in consideration therefor. There was no similar
contract in place to protect Coral from any depreciation of the currency.
CMRA 2's contract
[17] The contract between
CMRA 2 and Coral involved 120 projects that were to be completed by
December 31, 1986. The price per product was 13,157,894,737 cruzeiros,
for a total of 1,578,947,368,421 cruzeiros. The conditions regarding payment were
the same as those set out in the CMRA contract, except for the interest rate,
which was 11%.
[18] The initial project,
whose object was to obtain monoclonal antibodies that react with human
leukocyte antigens and human blood group antigens, was later changed. In early
1987, CMRA 2 decided to abandon the 60 human blood group antigen projects
after determining that Coral was unable to carry them out. On March 24, 1987,
the parties agreed that the contract would involve 42 projects. As part of
this transaction, CMRA 2 accepted the work done by Coral under the contract and
obtained the rights, title and interest in and to the 42 human leukocyte
antigen projects. The agreement dated March 24, 1987, defines the products
obtained by CMRA 2 as follows:
The parties acknowledge and
agree that the products in Exhibit 1 are supernatants which reacted at least
once with an identified HLS-specificity each of which requires additional work
to become a monoclonal antibody with reproducible activity produced by a stable
hybridoma, said monoclonal antibody to combine specifically in an immunological
manner with an identified HLA-specificity.
[19] On March 15, 1986, CMRA
2 notified Coral that it was aware that Brazil had abolished the cruzeiro, and
confirmed that it would be performing its obligations under its contract with
Coral on the basis of the new Brazilian currency, namely the cruzado.
[20] Over the course of
its fiscal year ended December 31, 1986, CMRA 2 paid Coral C$14,654,404,
which amounted to roughly C$350,000 for each of the 42 projects. CMRA also
issued notes in Brazilian currency payable to Coral in respect of the 42
projects, the total amount of the notes being 612,358,624 cruzados.
[21] In its financial
statements for the period from February 25 to December 31, 1986,
CMRA 2 entered a research expense of C$73,272,012 in respect of the service
contract entered into with Coral on February 25, 1986. In order to arrive
at this amount, CMRA 2 did the same thing as CMRA: it entered the initial
amount paid in cash as well as the value of the Brazilian-currency term notes
converted into Canadian dollars based on the exchange rate in effect on the
date of the transactions entered into with Coral.
[22] Like the CMRA notes,
the 13 CMRA 2 term notes contained no inflation adjustment formula, no monetary
adjustment formula and no exchange rate adjustment formula. In a Notice of Opportunity
dated July 28, 1986, Techmed specified that if CMRA 2 defaulted on
the payment of the total fees it owed to Coral under their contract, Coral would
have a remedy against the partnership's assets. The notice also specified that,
in such an event, Coral's remedy against any given partner would be limited to that
partner's debt to the partnership.
[23] Like the CMRA term
notes, the CMRA 2 term notes were assigned to MRT, but no demand was made, and
CMRA 2 and its members did not pay anything on the 13 term notes. The parties also
signed a hedge agreement like the one with CMRA, intended to protect CMRA 2 and
its members in the event that the Brazilian currency should appreciate, but there
was no contract to protect Coral from a depreciation of the currency. On June
17, 1986, Coral agreed, regarding the hedge agreement, that in view of Brazil's currency reform, the
contract was to be read as though it referred to cruzados.
[24] Before CMRA and CMRA
2’s contracts with Coral were signed, the partnerships' promoters did not
approach any firms other than Coral in connection with the performance of the
work contemplated in the contracts.
[25] In the wake of all
these events, a corporation named Les Associés de Recherche Médicale Canadienne
Inc. (ARMC Inc.) was incorporated under the Quebec Companies Act. The incorporators
were the Appellant Oleg Romar, the Appellant Yves Beaudry, and
one other person. An offer of exchange was made to the members of CMRA and CMRA
2, which involved the conversion of their partnership shares into common shares
of ARMC Inc. The purpose of
ARMC Inc. was to develop products based on research done by Coral.
[26] The ultimate
objective of that research was to develop diagnostic test kits. ARMC Inc. sold the cell
lines to Laval University for the
specific purpose of developing such test kits for commercialization. The
research activities were carried out at Coral's Cambridge laboratories; no activities took
place at the Brazilian laboratories. In light of the outcome of these
activities, CMRA and CMRA 2 claimed SR&ED expenses in excess of C$143,272,793,
thereby giving rise to losses in an equal amount for 1985 and 1986.
[27] The Appellants posted
non-capital losses (NCLs) and claimed carrying charges associated with their
investment, as well as NCL carry-overs to other taxation years.
[28] By notice of
assessment dated February 17, 2000, the Canada Revenue Agency disallowed
practically all of the amounts deducted by the Appellants and some 600 other
partners. Settlements were reached in all cases other than the Appellants'.
[29] Now that we have
reviewed the facts of the case, the main issues can be summarized as follows:
1. Do
the expenses claimed by the Appellants constitute SR&ED expenses within the
meaning of section 37 of the Act and section 2900 of the
Income Tax Regulations ("the Regulations")?
2. Do the financial
statements of the CMRA and CMRA 2 partnerships reflect the partnerships'
actual profits?
(a) Was an
expense actually incurred with respect to the term notes negotiated between
CMRA and CMRA 2?
(b) Were
the SR&ED expenses claimed by the Appellants reasonable within the meaning
of section 67 of the Act?
3. If the deductions
claimed were allowed, would they have the effect of unduly or artificially
reducing the Appellants' income as contemplated by subsection 245(1) as it
read at the time?
[30] Here, in very
succinct terms, is what the Respondent submits. The shares in the CMRA and
CMRA 2 partnerships were sold and presented as tax shelters. The two
partnerships had no clear and specific business plan based on commercial and
scientific practice. The expenses incurred by the partners are not reasonable
expenses within the meaning of section 67 of the Act, as regards the work
done by Coral.
[31] The Respondent argues
that the promoters and the partners in CMRA and CMRA 2 knew of the reputation
of the Brazilian cruzeiro and wanted to profit from the situation by setting up
tax shelters, which is why the contracts with Coral contained no monetary
adjustment clause, and so the members of the two partnerships did not have to repay
the true value of the debt that they had contracted.
[32] The Respondent further
submits that the financial statements of the partnerships in question were not
prepared in accordance with generally accepted accounting principles (GAAP), that
the value of the notes should have been discounted to reflect the depreciation
of the Brazilian currency and that the losses claimed were not actually incurred.
In the Respondent’s submission, the objective of the members of both
partnerships was purely tax-related: to claim losses that were created virtually
through the depreciation of the Brazilian currency, and thus subsection 245(1)
of the Act applies.
[33] For their part, the
Appellants submit that the work done by the Coral laboratory meets the criteria
with respect to SR&ED. In the alternative, they submit that their expenses were
nonetheless incurred in the operation of their business and are therefore
deductible under paragraph 18(1)(a) of the Act. They maintain that, in
the circumstances, the expenses were reasonable within the meaning of
section 67 of the Act. Lastly, they submit that the former
subsection 245(1) of the Act does not apply in the case at bar because the
deductions do not unduly or artificially reduce the partnerships' income.
[34] Each of the parties called
expert witnesses to testify concerning SR&ED, the Brazilian economy at the
time, and the GAAP in relation to the partnerships' financial statements. There
were also 16 witnesses who testified regarding the facts.
[35] Do the expenses
claimed constitute SR&ED expenses within the meaning of section 37 of
the Act and section 2900 of the Regulations?
The provisions
applicable to the years 1985-1986 are as follows:
37. Scientific research and experimental development
(1)
Where a taxpayer files with his return of income
under this Part for a taxation year a prescribed form containing prescribed
information, carried on a business in Canada and made expenditures in respect
of scientific research and experimental development in the year, there may be
deducted in computing his income for the year the amount, if any, by which the
aggregate of
(a) such amounts as may be claimed by the
taxpayer not exceeding all expenditures of a current nature made in Canada by the taxpayer in the year or in
any previous taxation year ending after 1973
(i) on scientific research and
experimental development related to the business and directly undertaken by or
on behalf of the taxpayer,
(ii) by payments to an approved
association that undertakes scientific research and experimental development
related to the class of business of the taxpayer,
(iii) by payments to an approved
university, college, research institute or other similar institution to be used
for scientific research and experimental development related to the class of
business of the taxpayer,
(iv) by payments to a corporation
resident in Canada and exempt
from tax under paragraph 149(1)(j), or
(v) by payments to a corporation
resident in Canada for
scientific research and experimental development related to the business of the
taxpayer;
(b) such amount as may be claimed by the
taxpayer not exceeding the lesser of
(i) the expenditures of a capital
nature made in Canada (by acquiring property other than land) in the year and
any previous year ending after 1958 on scientific research and experimental
development relating to the business and directly undertaken by or on behalf of
the taxpayer, and
(ii) the undepreciated capital cost
to the taxpayer of the property so acquired as of the end of the taxation year
(before making any deduction under this paragraph in computing the income of
the taxpayer for the taxation year),
(c) . . .
(c.1) all amounts included by virtue of
paragraph 12(1)(v) in computing the taxpayer's income for any previous
taxation year,
exceeds the aggregate of
(d) all amounts paid to him in
the year or in any previous taxation year ending after 1973 under an Appropriation
Act and on terms and conditions described in paragraph (c),
(e) that
portion of the aggregate of all amounts deducted under subsection 127(5)
in computing the tax otherwise payable by the taxpayer under this Part for the
year or any previous taxation year that may reasonably be attributed to
expenditures of a current nature made in Canada in the year or in any previous
taxation year that were qualified expenditures in respect of scientific
research and experimental development within the meaning of paragraph 127(10.1)(c),
(f) all amounts deducted by
virtue of this subsection and paragraph 20(1)(t) in computing the
taxpayer's income for any preceding taxation year, except amounts described in
subsection (6), and
(g) the aggregate of all amounts
each of which is an amount equal to twice the amount claimed under subparagraph
194(2)(a)(ii) by the taxpayer for the year or any preceding taxation
year.
(2) Research outside Canada – There may be deducted in
computing the income for a taxation year of a taxpayer who carried on business
in Canada and made expenditures in the year in respect of scientific research
and experimental development carried on outside Canada, all such expenditures of a current nature made in the year
(a)
on scientific research and experimental
development related to the business and directly undertaken by or on behalf of
the taxpayer, or
(b)
by payments to an approved association,
university, college, research institute or other similar institution to be used
for scientific research and experimental development related to the class of
business of the taxpayer.
(3) . . .
(4) Deductions – No deduction may be made
under this section in respect of an expenditure made to acquire rights in, or
arising out of, scientific research and experimental development.
(5) Idem – Where in respect of an
expenditure on scientific research and experimental development made by a
taxpayer in a taxation year an amount is deductible under this section and
under section 110, no deduction may be made in respect of the expenditure under
section 110 in computing the taxable income of the taxpayer for any taxation
year.
(6) Expenditures of a
capital nature – An amount claimed under paragraph (1)(b) in
computing a deduction under that subsection shall, for the purpose of section
13, be deemed to be an amount allowed to the taxpayer in respect of the
property acquired by the expenditures under regulations made under paragraph
20(1)(a), and for that purpose the property acquired by the expenditures
shall be deemed to be of a separate prescribed class.
(7)
Definitions – In
this section,
(a) . . .
(b) "Scientific research and
experimental development" - "scientific research and
experimental development" has the meaning given to that expression by regulation;
(c) [Expenditures on scientific
research and experimental development] – references to expenditures on or
in respect of scientific research and experimental development
(i)
where the references occur in subsection (2),
include only
(A)
expenditures each of which was an expenditure
incurred for and all or substantially all of which was attributable to the
prosecution of scientific research and experimental development, and
(B)
expenditures of a current nature that were
directly attributable, as determined by regulation, to the prosecution of
scientific research and experimental development, and
(ii)
where the references occur other than in
subsection (2), include only
(A)
expenditures each of which was an expenditure
incurred for and all or substantially all of which was attributable to the
prosecution, or to the provision of premises, facilities or equipment for the
prosecution, of scientific research and experimental development in Canada, and
(B)
expenditures of a current nature that were
directly attributable, as determined by regulation, to the prosecution, or to
the provision of premises, facilities or equipment for the prosecution, of
scientific research and experimental development in Canada; and
(d) [References to scientific research
and experimental development] – references to scientific research and
experimental development relating to a business or class of business include
any scientific research and experimental development that may lead to or
facilitate an extension of that business or, as the case may be, business of
that class.
[36] Under section 37, expenses
incurred to prosecute SR&ED may be deducted in computing a
taxpayer’s income from a business carried on actively. The definition of
scientific research is contained in section 2900 of the Regulations:
Part
XXIX
Scientific Research
Interpretation
2900. For the purposes of this Part and paragraphs 37(7)(b)
and 37.1(5)(e) of the Act, "scientific research" means
systematic investigation or search carried out in a field of science or
technology by means of experiment or analysis, that is to say,
(a) basic research, namely, work undertaken for the advancement of
scientific knowledge without a specific practical application in view,
(b) applied research, namely, work undertaken for the advancement of
scientific knowledge with a specific practical application in view, or
(c) development, namely, use of the results of basic or applied research
for the purpose of creating new, or improving existing, materials, devices,
products or processes,
and, where such activities are undertaken directly in support of
activities described in paragraph (a), (b) or (c),
includes activities with respect to engineering or design, operations research,
mathematical analysis or computer programming and psychological research, but
does not include activities with respect to
(d) market research or sales promotion;
(e) quality control or routine testing of materials, devices or
products;
(f) research in the social sciences or the humanities;
(g) prospecting, exploring or drilling for or producing minerals,
petroleum or natural gas;
(h) the commercial production of a new or improved material, device or
product or the commercial use of a new or improved process;
(i) style changes; or
(j) routine data collection.
[37] In addition, a body
of case law concerning SR&ED has been developed. In R I S
- Christie Ltd. v. Canada, [1996] T.C.J. No. 1056, Judge Sarchuk of this
Court considered the concept of SR&ED with respect to the 1982 and 1983
taxation years. The appellant had submitted as follows:
Appellant's Submissions
11 Pursuant to paragraphs 37(7)(b) and
37.1(5)(e) of the Act scientific research has the meaning given to that
expression by Regulation 2900. The Appellant relies on the evidence of Dorcich
and that of Littlejohn whose expert opinion was that the work conducted by
541185 was scientific research and experimental development. Their testimony
and a review of the proposal and the synopsis provide ample support that 541185
followed a formalized, scientific methodology and engaged in "systematic
investigation or research carried out in the field of science or technology by
means of experiment or analysis". More specifically, it conducted applied
research with respect to the electro-heating elements of the panel and the
adhesives and other materials to be used therein and engaged in the collection
of technical information and literature with respect to marketed concrete
forming systems that went beyond routine data collection. It was also engaged
in extensive development activities in which it analyzed and reviewed existing
materials and products to develop the panel. Thus the work performed by it
involved a real technical uncertainty, resulted in a new product and the product
was developed by using an organized and systematic approach. Furthermore, the
research undertaken by 541185 included activities "with respect to
engineering and design" as evidenced by its work with respect to the
structural, engineering and electrical design aspects of the panel. This
included the building of prototypes, the existence of which was confirmed by
the testimony of Dorcich, McCabe and Turner.
12
The Appellant asserts that it has met the Department of National Revenue's
technical guidelines as to what constitutes scientific research and development
for the purpose of subsection 2900(1) of the Regulations in that it has
satisfied the criteria of scientific or technological advancement; scientific
or technological uncertainty; and scientific and technical content.
[38] Judge Sarchuk also
took account of Information Circular 86-4R3 in analyzing the appellant's
activities. The following are the general criteria set out in that circular:
2.9 General criteria
2.10 Essential tests that
must be met before any activity can be considered scientific research and
experimental development include the criterion of scientific or technological
advancement; the criterion of scientific or technological uncertainty; and the
criterion of scientific and technical content.
2.10.1 The criterion of scientific or technological advancement
is as follows:
·
The search carried out in the scientific
research and experimental development activity must generate information that
advances our understanding of scientific relations or technologies. In a
business context, this means that when a new or improved product or process is
created, it must embody a scientific or technological advancement in order to
be eligible.
2.10.2 The criterion of scientific or technological uncertainty
is as follows:
·
Whether or not a given result or objective can
be achieved, and/or how to achieve it, is not known or determined on the basis
of generally available scientific or technological knowledge or experience.
This criterion implies that we cannot know the outcome of a project, or the
route by which it will be carried out without removing the technological or
scientific uncertainty through a program of scientific research or experimental
development. Specifically, scientific or technological uncertainty may occur in
either of two ways:
° it may be uncertain whether
the goals can be achieved at all; or
° the taxpayer may be fairly
confident that the goals can be achieved, but may be uncertain which of several
alternatives (i.e., paths, routes, approaches, equipment configurations, system
architectures, circuit techniques, etc.) will either work at all, or be
feasible to meet the desired specifications or cost targets, or both of these.
·
The scientific or technological uncertainty, rather
than the economic or financial risk, is important in characterizing scientific
research and experimental development -- and, hence, eligible
activities.
·
Sometimes there is little doubt that a product
or process can be produced to meet technological objectives when cost targets
are no object. In commercial reality, however, a reasonable cost target is
always an objective, and attempting to achieve a particular cost target can at
times create a technological challenge which needs to be resolved. A technological
uncertainty may thus arise that is imposed by economic considerations.
Otherwise, the more general question of the commercial viability of the product
or process is not relevant to whether or not a technological uncertainty is
present and, hence, to whether a project is eligible or ineligible.
·
This criterion applies equally to work on new or
existing processes or products. The description of technological uncertainty
contained in this subsection applies wherever the text of this circular refers to
the criterion.
2.10.3 The criterion of scientific and technical content is as
follows:
·
The scientific
research and experimental development activity must incorporate a systematic
investigation going from hypothesis formulation, through testing by experimentation
or analysis, to the statement of logical conclusions. Such experimentation
can include work on the evolution of prototypes or models. In a business
context, this means that the objectives of the scientific research and
experimental development projects must be clearly stated at an early stage in
the project's evolution. In addition, the method of experimentation or analysis
by which the scientific or technological uncertainties are to be addressed must
be clearly set out. Finally, the results of the succeeding scientific research
and experimental development efforts have to be properly identified. The need
for a systematic program of investigation does not preclude ideas that result
from intuitive processes. Such ideas are hypotheses, however, and must still be
tested through a systematic program before they can be accepted.
·
Qualified
personnel having relevant experience in science, technology, or engineering are
responsible for directing or performing the work.
[39] It is also entirely
appropriate to refer to the decision in C.W. Agencies Inc. v.
Canada, [2000] T.C.J. No. 558, in which Judge Bonner reviews the state
of the case law concerning the criteria applicable with respect to SR&ED
and reiterated the principles regarding the role of expert witnesses in cases
of this kind. I reproduce hereunder paragraphs 36 and 37 of that decision:
37 In Northwest the Court went on to
identify three basic criteria which apply to the determination of the question
whether SR&ED has taken place in a particular case. They are scientific or
technological uncertainty, scientific or technological content and scientific
or technological advancement. The Court explained those three elements or
criteria in language which is well worth repeating:
1.
Is there a technological risk or
uncertainty?
(a) Implicit in the term
"technological risk or uncertainty" in this context is the
requirement that it be a type of uncertainty that cannot be removed by routine
engineering or standard procedures. I am not talking about the fact that
whenever a problem is identified there may be some doubt concerning the way in
which it will be solved. If the resolution of the problem is reasonably
predictable using standard procedure or routine engineering there is no
technological uncertainty as used in this context.
(b) What is "routine
engineering"? It is this question, (as well as that relating to
technological advancement) that appears to have divided the experts more than
any other. Briefly it describes techniques, procedures and data that are
generally accessible to competent professionals in the field.
2.
Did the person claiming to
be doing SR&ED formulate hypotheses specifically aimed at reducing or
eliminating that technological uncertainty? This involves a five stage process:
(a) the
observation of the subject matter of the problem;
(b) the
formulation of a clear objective;
(c) the
identification and articulation of the technological uncertainty;
(d) the
formulation of an hypothesis or hypotheses designed to reduce or eliminate the
uncertainty;
(e) the
methodical and systematic testing of the hypotheses.
It is important to recognize
that although a technological uncertainty must be identified at the outset an
integral part of SR&ED is the identification of new technological
uncertainties as the research progresses and the use of the scientific method,
including intuition, creativity and sometimes genius in uncovering, recognizing
and resolving the new uncertainties.
3. Did the
procedures adopted accord with established and objective principles of
scientific method, characterized by trained and systematic observation,
measurement and experiment, and the formulation, testing and modification of
hypotheses?
(a)
It is
important to recognize that although the above methodology describes the
essential aspects of SR&ED, intuitive creativity and even genius may play a
crucial role in the process for the purposes of the definition of SR&ED.
These elements must however operate within the total discipline of the
scientific method.
(b)
What may
appear routine and obvious after the event may not have been before the work
was undertaken. What distinguishes routine activity from the methods required
by the definition of SR&ED in section 2900 of the Regulations is not solely
the adherence to systematic routines, but the adoption of the entire scientific
method described above, with a view to removing a technological uncertainty
through the formulation and testing of innovative and untested hypotheses.
4. Did
the process result in a technological advance, that is to say an advancement in
the general understanding?
(a) By
general I mean something that is known to, or, at all events, available to
persons knowledgeable in the field. I am not referring to a piece of knowledge
that may be known to someone somewhere. The scientific community is large, and
publishes in many languages. A technological advance in Canada does not cease to be one
merely because there is a theoretical possibility that a researcher in, say, China, may have made the same
advance but his or her work is not generally known.
(b) the
rejection after testing of an hypothesis is nonetheless an advance in this it
eliminates one hitherto untested hypothesis. Much scientific research involves
doing just that. The fact that the initial objective is not achieved
invalidates neither the hypothesis formed nor the methods used. On the contrary
it is possible that the very failure reinforces the measure of the
technological uncertainty.
5.
Although
the Income Tax Act and the Regulations do not say so explicitly, it
seems self-evident that a detailed record of the hypotheses, tests and results
be kept, and that it be kept as the work progresses.
38 The role of expert witnesses in cases such
as this was discussed by the Federal Court of Appeal in RIS Christie Ltd. v.
The Queen. At paragraph 12, Robertson J.A., speaking for the Court, stated:
What constitutes scientific research for the purposes
of the Act is either a question of law or a question of mixed law and fact to
be determined by the Tax Court of Canada, not expert witnesses, as is too
frequently assumed by counsel for both taxpayers and the Minister. An expert
may assist the court in evaluating technical evidence and seek to persuade it
that the research objective did not or could not lead to a technological
advancement. But, at the end of the day, the expert's role is limited to
providing the court with a set of prescription glasses through which technical
information may be viewed before being analyzed and weighed by the trial judge.
Undoubtedly, each opposing expert witness will attempt to ensure that its focal
specifications are adopted by the court. However, it is the prerogative of the
trial judge to prefer one prescription over another.
[40] The Appellants in
the case at bar submit that Coral's activities were applied research because
the work was undertaken for
the advancement of scientific knowledge with specific practical applications in
view. They
argue that the evidence that has been adduced shows that the investments in applied
research served to produce monoclonal antibodies that could ultimately be used
to develop diagnostic kits intended to test for certain diseases or infections.
[41] Hence, the first question
that must be asked is whether Coral's activities contributed to the advancement
of science and technology. More specifically, did Coral's activities result in
the creation of a new product or process or the improvement of an existing
product or process?
[42] In the case at bar,
the parties relied on the concept of the usefulness of the products. The
Appellants, for their part, argue that Coral's research did contribute to the advancement
of science because, at that time (1985–1986), there was no diagnostic test for
the viruses, parasites and proteins that were the subjects of the CMRA and
CMRA 2 projects. In support of this contention, they note that the cell
lines were sold to Laval University. The Respondent, for her part, argues that Coral was involved not in
scientific research, but, rather, in monoclonal antibody production, as their
experts Drs. Roger Kennett, Michael Norgard and Bernard Brodeur testified.
[43] The director of
Coral's laboratory in Cambridge confirmed the statements of the Respondent's three expert
witnesses; he said that Coral was not doing what he called "early stage
research". He added that "what we were doing was taking a technique
in order to make a product" or "using a tool to produce a product which
was labelled as research."
[44] Dr. Roger Kennett is
a professor of biology at Wheaton College in Texas. He prepared on behalf of the Respondent four expert
reports regarding CMRA and CMRA 2, the purpose of which was to evaluate the SR&ED
work that was done, determine whether the final products could be
commercialized, and assess the cost of producing monoclonal antibodies. Dr.
Kennett stated that as far as viral, peptide and parasite antigens are
concerned, the technology was known to the scientific community at the time and
did not warrant further research. According to Dr. Kennett, the Coral projects
did not contribute to the advancement of science in any way. In his view,
Coral's work solely consisted in producing monoclonal antibodies, with no
regard to their specificity or antigen sensitivity. There was no SR or ED in
the ARMC and ARMC 2
projects since the procedures, protocols and hypotheses proposed by Coral had
not been verified through experiments or analyses that would have led to a
logical conclusion. However, he did acknowledge that even if certain products
exist on the market, some companies will continue to do research on them in
order to develop similar products or products with certain distinguishing
features.
[45] The CMRA and
CMRA 2 project nonetheless aroused interest in scientific circles. In
the course of her testimony, Francine Décary, President and CEO of Hema-Québec, stated
that in 1988, when she was the medical director of transfusion services with
the Red Cross, she was approached by CMRA to work on a project entitled
"Production d’anticorps monoclonaux humains anti-HLA" (Production of
anti-HLA human monoclonal antibodies). The goal was to pursue the work
initiated by Coral, which consisted in developing technology to produce ten or
so anti-HLA human monoclonal antibodies. Her interest stemmed from the fact
that at the time (and even today), there were no anti-HLA monoclonal antibodies
derived from human samples. The project, which was to have taken two years and
cost C$677,000, never got off the ground; the witness was not aware of the
reasons for this, nor did she know what had become of the antibody producing
cells that had been supplied.
[46] Ghislaine Martin, a
special advisor at Laval University, testified that the university purchased type I and type
II herpes simplex cell lines from ARMC in 1993, as well as Entamoeba histolytica cell
lines in 1999.
[47] Dr.
Michel Pagé, a professor of biochemistry at Laval University, provided testimony
regarding the various contracts for the purchase of cell lines that the
university signed with ARMC with a view to developing test kits for cytomegalovirus
and herpes simplex types I and II. He indicated that the Entamoeba
histolytica cell lines purchased in 1991 cost C$470,000. However, he did
not believe that the cytomegalovirus and herpes simplex kits had ultimately
generated any income.
[48] For reasons of
quantification, specificity and sensitivity, Dr. Pagé produced, as part of this
research, other cell lines with those acquired from CMRA. The witness
explained that the technique he was using required cell lines in addition to
those provided by ARMC and that he had had to carry out a considerable amount
of additional research with the ARMC cell lines in order to obtain a marketable product. He did
indicate, however, that all the required cell lines ultimately produced the antibodies
they were supposed to produce.
[49] In light of this
evidence, the answer to the question asked could arguably be that CMRA and
CMRA 2's projects did contribute to the advancement of science in the
sense that the projects involved the development of new products or the improvement
of existing products.
[50] The second question
that must be asked is whether there was scientific or technological uncertainty
regarding the activities in which Coral was engaged. What must be determined is
whether Coral, upon commencing its work, knew the probability of attaining its
goals or a given result, or how it would achieve the goals or result.
[51] The Appellants
submit that this criterion is met in the case at bar because some of CMRA and CMRA
2's projects were successful and others were not. From the testimony given by
the witnesses, it can be seen that in 1985–1986, there was considerable
enthusiasm for the type of research that Coral was doing. Dr. Kennett admitted
that research on monoclonal antibodies involved risk and the Appellants infer
from this admission that uncertainty has been demonstrated. According to Dr.
Kennett, one is not always certain that the results hoped for will be achieved.
In my opinion, it was therefore impossible for Coral to know which projects
would ultimately be successful.
[52] Neither the
probability of attaining objectives nor the manner in which they might be
attained can be known or determined in advance on the basis of the state of
scientific or technological knowledge. It can therefore be said that Coral
cannot have known the outcome of the project or how to carry it out, and thus, there
was technological uncertainty as to whether antibodies could be produced for
all the viruses, parasites and other organisms for which Coral was attempting
to develop antibodies.
[53] Thirdly, it must be
asked whether Coral's activities had scientific and technical content. I come
back to the decision in C.W. Agencies, supra, in which Judge Bonner
reiterated the three fundamental criteria set out in Northwest and the
five‑step process intended to eliminate such technological uncertainty:
(a) the
observation of the subject matter of the problem;
(b) the
formulation of a clear objective;
(c) the
identification and articulation of the technological uncertainty;
(d) the
formulation of an hypothesis or hypotheses designed to reduce or eliminate the
uncertainty; and
(e) the
methodical and systematic testing of the hypotheses.
[54] The Appellants
submit that Coral's activities met this third criterion because, according to
the testimony, Coral's laboratory staff was qualified, hypotheses were
formulated (despite the fact that the scientists did not all agree on their
validity; they did point out, however, that an inexact hypothesis nonetheless
advances science), and there were laboratory log books. They submit that the
criterion is met where there is a systematic investigation of the hypotheses or
tests, with experimentation, analysis and conclusions.
[55] The Respondent, for
her part, rejects this argument, in view of the clear depositions of her expert
witnesses.
[56] Dr. Bernard Brodeur
is a biotechnology consultant and retired Laval University professor. During the
period in question, he headed the diagnostic reagents division of the
Laboratory Centre for Disease Control (Health Canada) in Ottawa. He was appointed as the
scientific expert for findings and opinions regarding the work being carried
out at the Coral laboratory for CMRA and CMRA 2.
[57] The mission that he
was given by the Canada Revenue Agency in December 1987 was to evaluate
the nature, extent and quality of the research activities reported by the Coral
laboratories with respect to two different programs, namely the production of
murine monoclonal antibodies capable of combating bacteria antigens, virus
antigens, parasite antigens and certain human protein antigens, and the
production of human monoclonal antibodies capable of combating human leukocyte
and blood group antigens, the objective, in both cases, being to create
diagnostic kits for the detection of diseases. He therefore prepared
expert reports on the CMRA and CMRA 2 projects.
[58] In his expert
reports, Dr. Brodeur indicated that Coral had the capacity to culture cells
capable of producing antibodies, but that it did not have the microbiology
laboratory facilities needed to work with human pathogens in order to validate
its results; these pathogens were essential to developing research projects in
which infections would be followed in a live animal. That step constitutes the
validation of the results. According to Dr. Brodeur, Coral had sought to
compensate for this deficiency by turning to other, less accurate solutions in
which the antibodies created were not always capable of recognizing the
specific antigen. In his testimony, he indicated to the Court that, in his
view, the procedures, protocols and hypotheses proposed by Coral were not
verified through experiments or analyses that might have led to a logical
conclusion. He asserted, in his expert capacity, that specificity and affinity
are essential for antibodies as they must be able to recognize the target
antigen with a high degree of accuracy, since a disease can comprise several
antigen groups, in very limited quantities, which can sometimes be broken down
into several different types. He further maintained that the laboratory
personnel were indeed producing antibodies but were not aware of the properties
of these antibodies, since none of them knew the exact type of antigen with
which the antibodies produced could react.
[59] Dr. Brodeur observed the
following anomalies with respect to Coral:
1.
the
absence of an animal research facility to perform the immunization tests;
2.
a lack
of microbiology expertise;
3.
an
error in the antigen screening method used;
4.
the
purification and conjugation methods (conjugation of antibodies with a chemical
molecule to create a detector antibody, which is essential for establishing diagnostic
tests) were consistent with current standards;
5.
certain
conjugations, even where there were very weak sensitivity findings, were
considered by Coral to be successful, and the project was then viewed as
completed;
6.
there
was no evidence of on-site clinical assessments;
7.
there
was a lack of project management, since Coral limited itself to the production
of large quantities of antibodies in a rather hit-or-miss fashion, and was not seeking
to discover specific monoclonal antibodies capable of detecting specific
diseases;
8.
Coral
never discovered antibodies that were ready for clinical trials since
characterization was markedly lacking;
9.
when
Coral encountered an obstacle in its research, the project would simply be
abandoned;
10. there was only one
specialist in monoclonal antibodies (Bruce Wright); the other laboratory staff
members were merely assistants; Robert Mason was an immunology expert.
[60] The witness
concluded from all of the above that Coral was not engaged in research, but
rather, was on a fishing expedition in which routine and very quick methods
were used.
[61] As for the
laboratory log books, Dr. Kennett stated that they did not meet industry
standards and would not have been sufficient to secure a patent. In fact,
the evidence shows that the log books contained, rather, summary information
that simply indicated whether a given project had been successful or not. In my
opinion, it would appear that Coral's activities were devoid of any scientific
content. There is no evidence to suggest that Coral had formulated any hypotheses
with respect to the success or lack of success of its research activities.
[62] Still, on his first
visit to Cambridge on July 19, 1985, Dr. Norgard had observed that the laboratory
was adequate, that its personnel was qualified, that research activities were
underway and that mice were being used in the laboratory. However, he also observed,
as did Dr. Brodeur, that the "screening panels"
were unsatisfactory. In his second report, he concluded that the great
majority of Coral's projects had no scientific merit. He based this conclusion
on the fact that the antibodies obtained were incapable of identifying specific
antigens for a specific species of pathogen and could only provide a very
summary diagnosis, which would have been of no value in the type of diagnostic
kit required. He even referred to the work as a waste of resources.
[63] Reproduced below are
the findings contained in his report with respect to the fundamental reason for
such research projects:
. . . my opinion is that the
overwhelming majority of these really were formulated on the basis of
oversights, erroneous hypotheses, I think they use misleading rationales, there
was certainly ignorance of relevant diagnostic issues and all the very
superficial considerations of the scientific approaches, not to mention the
lack of scientific rigor because again many of these projects there was a
little activity and they suddenly terminated, there was no good faith effort in
really trying to show a genuine attempt to carry them out. I think that the
CMRA partners did not do the customary due diligence in selecting these kinds
of projects that lacked scientific merit, lacked of diagnostic rationales. And
I don't even think that the Coral activities represented bona fide scientific
research. They only wanted to project an image of scientific
credibility [page 59].
[64] Dr. Norgard also
produced a rebuttal to the report of Dr. Pradip Banerjee, the Appellant's
expert, which he criticizes for not having considered the utility of the
monoclonal antibodies, their raison d'être, why they were needed, and their
practical application. Moreover, he states that the report provides no
breakdown of the figures on which the expert relied. In Dr. Norgard's opinion,
the development of antibodies represents in fact only 10% of the production
costs of a diagnostic kit, and he states that C$1.75 million is unreasonable
under the circumstances.
[65] As we have seen, Dr.
Kennett found with respect to CMRA that there was no SR&ED because the procedures,
protocols and hypotheses proposed by Coral were not verified by experiments or
analyses that would have led to a logical conclusion. He expressed the
same view about CMRA 2. He found that the work carried out consisted solely in
producing antibodies, not to mention the fact that the quantities produced were
small and chemically useless. He briefly commented on the following situations with
regard to CMRA 2:
1.
in
1986, there were already standardized protocols for producing antibodies from
mouse cells;
2.
for
reasons of technical difficulty, it was not a good idea to use human cells to
produce antibodies; mouse cells would have been good enough;
3.
at
the time, it was not possible to produce antibodies of each category, because that
would have required more time;
4.
the
contract with CMRA 2 led to no scientific innovation.
[66] In light of the
evidence adduced by the Respondent, I am unable to conclude, on a balance of
probabilities, that Coral's activities in relation to either the CMRA or the CMRA 2
project had scientific content. Thus, I find that Coral's work for CMRA and
CMRA 2 did not truly constitute SR&ED.
Question 2A
[67] Since the Respondent
admitted that CMRA and CMRA 2 operated a business, we must now ask whether an
expense was truly incurred with respect to the term notes issued by CMRA to
Coral and by CMRA 2 to Coral. In the Respondent’s alternative submission, CMRA
and CMRA 2 did not report their profits in the manner that most accurately
reflected their business in accordance with the GAAP that prevailed at the
time.
[68] As we have seen,
under the terms of payment set out in the contract between CMRA and Coral dated
July 16, 1985, the fees were payable in Brazilian cruzeiros at 7,990,867,500
cruzeiros per product, for a total of 455,479,447,500 cruzeiros for the
57 products contemplated in the contract. Twenty per cent of that amount
was payable in cash before December 31, 1985 – which percentage was paid
in Canadian currency – and 80% was payable in the form of a term note payable
in four equal annual instalments in Brazilian currency, commencing in the
seventh year, that is to say, in 1992, 1993, 1994 and 1995, at the exchange
rate in effect on the date that the shares were issued in 1985, plus simple
interest at a rate of 11.5% on each of the four instalments.
[69] Under the terms of
payment set out in the contract dated February 25, 1986, between CMRA
2 and Coral, the fees were payable in Brazilian funds at 13,157,894,737
cruzeiros per product, for a total of 1,578,947,368,421 cruzeiros for the 120
products referred to in the initial contract, and were payable in the same manner
as that specified in the previous year's contract, except that the interest rate
was 11%.
[70] It should also be
noted that both of the contracts in question contained an adjustment clause
stating that the amounts payable in Brazilian funds represented the equivalent
of C$1,750,000 per project on the effective date of the contracts, namely
July 16, 1985 and January 2, 1986, respectively. The adjustment
clause also provided that the amounts in Brazilian currency were also to correspond
to C$1,750,000 on the date set by the contracts for the payment of the 20% in
cash. However, the clause excluded any other adjustment for the payments under
the term notes. Thus, the clause protected Coral against any depreciation of
the Brazilian currency between the date of the contracts and the date of the
cash payment (the 20%).
[71] At the time, it was
known that the Brazilian currency was undergoing rapid devaluations and that
inflation was on the rise. The testimony, and in particular the expert
testimony, makes this clear.
[72] CMRA and CMRA 2 reported
cash payments to Coral, in Canadian funds, totalling $14,000,158 and $14,654,404,
in their respective fiscal years. In addition, both partnerships reported
more than $70 million in research expenses in their respective financial
statements. The expenses include the $14 million in cash payments in Canadian
funds, but they also include the principal on the Brazilian-currency term
notes, converted into Canadian funds at the exchange rate in effect on the date
that each note was subscribed in 1985 and 1986. It is in this manner that CMRA entered
C$70 million in research expenses in its financial statements for 1985, and
CMRA 2 entered C$73 million in such expenses in its financial statements for 1986.
[73] The Respondent's
position on the issue of whether the amounts deducted with respect to the demand
notes, namely C$56 million for CMRA and C$58 million for CMRA 2,
is that they were not expenses that were paid or incurred, but were instead
contingent liabilities that were uncertain, and that were, indeed, entirely
unlikely to arise under the circumstances. As for the Appellants, their
position is that in order for an expense to be deductible, it must be incurred for
the purpose of gaining or producing income from a business or property. Thus,
they submit that, to the extent that the expense was incurred, it can be
deducted.
[74] At the time that the
relevant facts arose, subparagraph 18(1)(a) of the Act read as follows:
18.(1) General limitations
In computing the income of a taxpayer from a business or property no
deduction shall be made in respect of
(a) General limitation - an outlay or expense except to the
extent that it was made or incurred by the taxpayer for the purpose of gaining
or producing income from the business or property;
18.(1) Exceptions d’ordre général
Dans le calcul du revenu du contribuable tiré d'une
entreprise ou d'un bien, les éléments suivants ne sont pas déductibles :
a) Idem. – un débours ou
une dépense sauf dans la mesure où ce débours ou cette dépense a été fait
ou engagé par le contribuable en vue de tirer un revenu de l'entreprise
ou du bien;
[Emphasis added.]
That subparagraph now reads:
18.(1) General limitations
In computing the income of a taxpayer from a business or property no
deduction shall be made in respect of
(a) General limitation - an outlay or expense except to the
extent that it was made or incurred by the taxpayer for the purpose of gaining
or producing income from the business or property;
18.(1) Exceptions d’ordre général
Dans le calcul du revenu du contribuable tiré d'une
entreprise ou d'un bien, les éléments suivants ne sont pas déductibles :
a) Restriction générale - les dépenses, sauf dans la
mesure où elles ont été engagées ou effectuées par le contribuable en vue de
tirer un revenu de l'entreprise ou du bien.
[75] Since the French verbs
"faire" and "effectuer" have the same meaning,
the recent case law is relevant to the former French version of the provision. The Grand Robert de la
langue française gives the following definitions:
EFFECTUER v. tr.
1. Mettre à effet, à
exécution. Þ Accomplir, tenir.
2. Mener à bien, faire, exécuter (une opération
complexe ou délicate, technique, etc.). Þ Accomplir,
faire, réaliser.
FAIT, FAITE adj. Þ Faire
FAIRE v. tr.
. . .
2. Effectuer (une
opération, un travail); s’occuper à qqch. Þ Effectuer,
exécuter, opérer . . .
[76] The concept of an incurred expense has been considered in a
number of decisions, and what must be remembered is that there must be an obligation
to pay money in order for an expense to be incurred (see the decisions in The
Queen v. Burns, [1984] 2 F.C. 218 (F.C.A.) and Newfoundland
Light & Power Co. Ltd. v. The Queen, 90 DTC 5166 (F.C.A.))
and the expense is incurred in the year that the liability comes into
existence. Madam Justice Sharlow of the Federal Court of Appeal made the
following comments on this question in Wawang Forest Products Ltd. v.
Canada, [2001] F.C.J. No. 449:
30 Desjardins J.A. added obiter dicta
to the effect that the amounts could not be recognized for tax purposes in the
absence of proof that third party claims had been satisfied, because until that
was done the quantum of the liability was uncertain. She also relied on
the fact that part of the amount claimed had not been paid. I must respectfully
disagree with these comments. In my view, a legal obligation to pay an amount
may exist even if there is some risk that the actual payment may be set off
against potential counterclaims. Similarly, the fact that a liability remains
unpaid does not mean that it never came into existence. For these reasons, I
reject the argument of the Crown in this case that the taxpayers' contractual
right of setoff for trespass penalties, or the fact that some of the holdbacks
remained unpaid in 1994, proves that the holdbacks were contingent liabilities
in the years under appeal.
[77] With respect to the
question of contingent liabilities, which was raised by the Respondent herein the
following remarks by Madam Justice Sharlow in Wawang, supra, shed
light on the appropriate test and its application:
11 The generally accepted test for
determining whether a liability is contingent comes from Winter and Others
(Executors of Sir Arthur Munro Sutherland (deceased)) v. Inland Revenue
Commissioners, [1963] A.C. 235 (H.L.),
in which Lord Guest said this (at page 262):
I should define a contingency as an event which
may or may not occur and a contingent liability as a liability which depends
for its existence upon an event which may or may not happen.
12 The same understanding of the meaning of
"contingency" underlies many tax decisions in this Court and other
courts, including Harlequin Enterprises Limited v. The Queen, [1977] 2 F.C. 579, [1974] C.T.C. 838, 74
D.T.C. 6634 (F.C.A.), Mandel v. The Queen, [1979] 1 F.C. 560, [1978] C.T.C. 780, 78
D.T.C. 6518 (F.C.A.), Perini Estate v. Canada, (1982), 40 N.R. 74, [1982]
C.T.C. 74, 82 D.T.C. 6080 (F.C.A.), and Canadian Pacific Limited
v. Ontario (Minister of Revenue), [1998] 41 O.R. (3d) 606, 114
O.A.C. 217, [2000] C.T.C. 331, 99 D.T.C. 5286 (Ont. C.A.).
13 The Winter test has become confused
by some obiter dicta in Samuel F. Investments Limited v.
M.N.R., [1998] 1 C.T.C. 2181, 88 D.T.C. 1106 (T.C.C.), one of the cases
cited by counsel for the Crown in this appeal. In that case the Tax Court Judge
relied on Winter in concluding that a certain obligation was contingent.
In my view, he reached the correct conclusion on the facts. However, in his
reasons for decision he said this:
My understanding is that a liability to make a
payment is contingent if the terms of its creation include uncertainty in
respect of any of these three things: (1) whether the payment will be made; (2)
the amount payable; or (3) the time by which payment shall be made.
14 It is fair to say that
these three uncertainties may be characteristic of contingent liabilities in
some circumstances. However, the Crown argues in this case that the existence
of these three uncertainties are [sic] now the test for determining
whether a liability is contingent. In support of its position, counsel for the
Crown cites Barbican Properties Inc. v. Canada, [1996] 2 C.T.C. 2615, 97
D.T.C. 122 (T.C.C.), affirmed, [1997] 1 C.T.C. 2383, 97 D.T.C. 5008 (F.C.A.).
In my view, that case does not stand for the proposition for which the Crown
cites it. The Tax Court Judge in Barbican did recite the three
uncertainties from Samuel F. Investments, but only after he had already
concluded that the liability in issue was contingent because its existence
depended upon the occurrence of a contingent event. In other words, the
liabilities in Barbican were contingent in accordance with the
definition in Winter and also met the three uncertainties stated in the Samuel
F. Investments case. This Court endorsed his reasons. However, I
cannot accept that the Tax Court Judge or this Court intended to replace the Winter
test for contingent liabilities with a different one based on Samuel F.
Investments.
15 The "three uncertainties"
listed in Samuel F. Investments cannot by themselves determine whether a
liability is contingent. For example, with respect to the uncertainty as to
payment, a taxpayer may incur an obligation at a time when it is in financial
difficulty, with the result that there is a significant risk of non-payment.
But that uncertainty cannot mean that the obligation was never incurred.
Similarly, an obligation to pay a certain amount does not become a
contingent obligation merely because events may occur that result in a
reduction in the quantum of the liability (see, for example, Canadian
Pacific, cited above). Nor does a legal obligation to pay an amount become
contingent merely because payment may be postponed in certain events or no date
is stipulated for payment. Parties are entitled to rely on the ordinary
contract law principle that payment for services must be made within a
reasonable time.
16 Returning to the Winter
test, the correct question to ask, in determining whether a legal obligation is
contingent at a particular point in time, is whether the legal obligation has
come into existence at that time, or whether no obligation will come into
existence until the occurrence of an event that may not occur. For example, Winter
establishes that where tax is payable on the gain realized on the sale of an
asset, the obligation to pay the tax is a contingent liability unless the asset
is sold. An obligation to pay an amount equal to a percentage of earned
revenues is a contingent obligation unless the revenues are earned (Mandel,
cited above). An obligation to pay a management bonus if the money is
available is a contingent obligation unless the money is available (The
Queen v. Ken and Ray's Collins Bay Supermarket, [1975] C.T.C. 504, 75 D.T.C. 5346 (F.C.T.D.),
confirmed without written reasons (F.C.A.), leave to appeal to the Supreme
Court of Canada refused: [1978] 1 S.C.R. ix).
[78] Here, then, is the
right question to ask in the case at bar in order to decide whether a liability
is contingent: Did the legal obligation to pay the notes exist at the precise
moment that they were signed, or would it come into existence only if an
uncertain event occurred? The Respondent submits that the test has been
met because the Appellants knew, upon negotiating the research contracts, that
the Brazilian currency would depreciate and that the notes would be worthless
at the time that they would become payable.
[79] In support of this
submission, the Respondent cites Global Communications Ltd. v.
Canada, [1999] F.C.J. No. 966, a decision of the Federal Court of
Appeal concerning such contingent liabilities, in which it was held that an
expense that might never be incurred could not be deducted. In Global Communications,
the Court held that the notes were contingent liabilities because payment on
the notes was due only if licensing revenue was generated, and the generation
of such revenue was an uncertain event.
[80] In McLarty v.
Canada, [2006] F.C.J. No. 656, the Federal Court of Appeal was faced with
this issue again, and came to the opposite conclusion in considering whether
notes gave rise to a contingent liability as regards their payment. The Court stated,
in relevant part:
31. A determination of whether an expense has been incurred or if
the obligation is merely a contingent liability is a question of mixed fact and
law. Consequently, the applicable standard of review is that of palpable and
overriding error. General Motors of Canada Ltd. v. The Queen, 2004
FCA 370 at para. 14.
32. If the Note had only required repayment
provided there were revenues from the licensing of the Data or from the
drilling program, then the Note may well have been contingent. However, section
7 of the Note stated:
7. If the indebtedness created hereby either
with respect to principal or interest remains in whole or in part unpaid as of December 31, 1999, the Noteholder will appoint an independent trustee to
sell for cash only:
a. the Technical Assets; and
b. an undivided 20% of the undersigned's
Participating Interest in Petroleum Rights acquired by the Joint Venture
pursuant to the Drilling Program.
The proceeds of the sale will be
allocated as follows:
a. Technical Assets:
i. 60% (net of commissions, if any)
to the Noteholder as a reduction of amounts owing by the undersigned under this
promissory note; and
ii. 40% (net commissions, if any) to the
undersigned;
b. an undivided 20% of the undersigned's
Participating Interest in Petroleum Rights acquired by the Joint Venture
pursuant to the Drilling Program:
100% to the Noteholder as a reduction of amounts
owing by the undersigned under this promissory note, allocated firstly as to
interest and the remainder as to principal.
Any balance owing by the undersigned on this
note after the allocation of the proceeds of the sale as described above will
be forgiven by the Noteholder and the undersigned will have no further
liability under this promissory note.
33. Indeed, the TCC's analysis of the contingent nature of the
respondent's obligation turned on this final aspect of the Note. In the mind of
the TCC judge, the Note was
contingent if there was some uncertainty if the Data could be sold. According
to McLarty at para. 49:
Ultimately, to determine whether the Appellant's
Note is a contingent liability it is necessary to look at the surrounding
facts. The ongoing market for quality seismic data, and relative rarity of such
quality (especially at the time the Venture Data was purchased) leads me to the
determination that the Venture Data could be sold. I find that at the time the
Appellant purchased his interest in the Venture Data there was no contingent
liability because the Venture Data was required to be and could be sold upon
default.
34. It is not clear to me that it was necessary to consider whether
the Data could be sold. It seems to me that one could determine whether the
Note was contingent, simply by reading it.
35. In Wawang at paras. 13, 15 and 16, this
court stated the following about the nature of a contingent obligation:
para. 13 The Winter test has become
confused by some obiter dicta in Samuel F. Investments Limited v.
M.N.R., [1988] 1 C.T.C. 2181, 88 D.T.C. 1106 (T.C.C.) . . . In that case
the Tax Court Judge relied on Winter in concluding that a certain
obligation was contingent. In my view, he reached the correct conclusion on the
facts. However, in his reasons for decision he said this:
My understanding is that a liability to make a payment
is contingent if the terms of its creation include uncertainty in respect of
any of these three things: (1) whether the payment will be made; (2) the amount
payable; or (3) the time by which payment shall be made.
. . .
para 15 The "three uncertainties"
listed in Samuel F. Investments cannot by themselves determine whether a
liability is contingent. For example, with respect to the uncertainty as
to payment, a taxpayer may incur an obligation at a time when it is in
financial difficulty, with the result that there is a significant risk of
non-payment. But that uncertainty cannot mean that the obligation was never incurred.
Similarly, an obligation to pay a certain amount does not become a contingent
obligation merely because events may occur that result in a reduction in the
quantum of the liability (see, for example, Canadian Pacific, cited
above). Nor does a legal obligation to pay an amount become contingent merely
because payment may be postponed in certain events or no date is stipulated for
payment. Parties are entitled to rely on the ordinary contract law principle
that payment for services must be made within a reasonable time.
para. 16 Returning to the Winter test, the
correct question to ask, in determining whether a legal obligation is
contingent at a particular point in time, is whether the legal obligation has
come into existence at that time, or whether no obligation will come into
existence until the occurrence of an event that may not occur. . . .
36. In this instance, a plain reading of the Note reveals
that the respondent's liability was not contingent. Instead, his legal
obligation came into existence when the Note was signed.
37. The terms of the Note themselves reveal that the respondent's
liability did not depend on the occurrence of an uncertain event. The Note
dictated that the respondent was obliged to pay the noteholder if there were revenues
from the licensing of the Data or from the drilling program. Even if there were
no such revenues, the respondent was not free from any legal obligations.
According to the Note, if the debt remained unsatisfied by December 31, 1999,
the noteholder could appoint an independent trustee to sell the Data and part
of the respondent's interest in any petroleum rights acquired by the Joint
Venture. In other words, regardless of whether the Data or drilling program
generated revenues, the respondent was obliged to surrender property for the
benefit of the noteholder.
38. My conclusion that section 7 of the Note results in its being an
absolute obligation is sustained by Frederick W. Hill v. The Queen, 2002 DTC 1749 (T.C.C.). In that case, the TCC considered whether interest
amounts in relation to a limited recourse mortgage were contingent liabilities.
Even though the mortgagee could not seek any deficiency under the mortgage from
the mortgagor, the TCC found no
contingency. After all, the mortgagee could always take possession of or sell
the land.
39. The appellant objects to these lines of reasoning by pointing to
Global Communications. It is true that the structure of the note in that
case seems similar to that of the Note in the present one. The Global Communications
note obliged the taxpayer to pay the noteholder, if and when received, a
percentage of net revenues from the sale or licensing of the taxpayer's seismic
data and a percentage of net oil and gas revenues. Recourse under the Global
Communications note was also limited to the liquidation of the seismic data
and any oil and gas leases held when the note matured. Unfortunately, the court
in Global Communications did not appear to consider this final aspect of
the note before it in determining that the note represented a contingent
liability. Therefore, this case is not of particular assistance in the present
one.
40. In conclusion, then, the court below reached the right result
when it equated the Note with an incurred expense.
[81] The actual thrust of
these remarks is that where payments are contingent on revenues, the fact that
there is a provision for fulfilling the obligations by some other means does
not cause the payment to be an uncertain event.
[82] In the case at bar,
are there contingent liabilities with respect to payment to Coral by CMRA and
CMRA 2 under the term notes? Is payment contingent upon the occurrence of
an uncertain event?
[83] Each party called
expert witnesses. The Appellant called John Williamson, an economist with considerable
experience in international monetary issues. The purpose of his report was
to state his opinion as to whether the Brazilian cruzeiro had the potential for
rapid inflation in 1985 and 1986. He addressed several matters in his report,
including the historical profile of Brazilian currency after World War II.
He stated that Brazil had faced repeated waves of inflation and monetary devaluation since the
end of the 1950s. He reviewed the three schools of thought on solving Brazil's inflation problem and
the various measures taken by the Brazilian government in the 1980s. His conclusion
was that, in 1985 and 1986, it was impossible to predict that very high
inflation in Brazil would be inevitable. In his view, it was not possible to predict
hyperinflation at that time, because that phenomenon depended on the country's
political system and on the effect of stabilization programs. Consequently, he
could not have predicted that the Brazilian currency would depreciate greatly
in relation to the Canadian dollar within 7-10 years. I must note that the
reasons that prompted this witness to make that assertion were not expressly stated,
though the witness did allude to various recovery plans that were implemented.
[84] The witness also
submitted a rebuttal to the reports prepared by the Respondent's experts, Dr. William
Cline and Dr. James W. Hoag. Dr. Cline holds a doctorate in
economics. He has taught in Brazil and worked for the country's Ministry of Planning.
From 1981 to 1989, he published a number of articles on Latin America's
economy and wrote several on the Brazilian economy in particular. He prepared
an expert report for CMRA, an expert report for CMRA 2, a rebuttal of
Mr. Williamson's report, and a comment in that regard dated March 22, 2006.
[85] Dr. Cline testified
as to the fair market value of the notes in 1985 for CMRA and in 1986 for
CMRA 2. In order to address this issue, he had to assess the anticipated
inflation rate in Brazil for the ten years following the issuance of the notes. In his view,
the financial community was clearly predicting a marked and constant
depreciation of the Brazilian currency in relation to the Canadian currency.
He relied on historical Brazilian data from 1959 to 1985 and asserted that
there were warning signs regarding the success of Brazil's recovery plan. Dr. Cline
testified that unless this anticipated depreciation of Brazil's currency was offset by high
interest rates on the notes, which it was not, it would necessarily cause a
considerable reduction in the fair market value of the notes in relation to
their face value.
[86] The witness's
conclusion regarding the actual value of the CMRA notes was as follows: "My
assessment is that the fair market value of those notes when they were signed
was less than one tenth of one cent on the dollar." This assessment was
based on the fact that one had to consider the variations in the exchange rate
for the Brazilian currency in relation to that for the Canadian currency over
the years. In this regard, he stated:
The central premise of my study is that, to anticipate what the
future exchange rate would be between the Brazilian currency and the Canadian
currency, it was necessary to take account of a differential inflation. And
that because Brazilian inflation was expected to be much higher than Canadian
inflation, it was necessary, for a period stretching ten years, to
systematically strip out the loss of value that would occur for the Canadians
year after year because of higher inflation in Brazil than in Canada. The
premise of this in fact is so formal that it's called, in Economics, the
Purchasing Power Parody Theorem. And this theorem holds precisely that you can
expect one currency to depreciate relative to another currency at a rate that
equals the difference between inflation in the first country and the inflation
in the second country.
[87] With respect to the CMRA
2 notes, he stated: "My estimate is that at the time they were signed, in
aggregate, these notes were worth seven point seven cents on the dollar."
His reasoning consisted of the same argument as that put forward with respect
to CMRA, except that the inflation rate was reduced from 250% to 50% for
CMRA 2. In both cases, the witness maintained that the term notes did not
constitute standard business practice. This is because they did not have an
indexation mechanism to offset inflation. The witness said that the lack of
indexation was contrary to business practice at that time because no one wanted
to run the risk of having their projects go up in smoke due to inflation.
The interest rate stipulated in the notes did not reflect the reality of Brazil's financial market
because, according to statistics, the country's interest rate at the time was
excessively high.
[88] Dr. James Hoag was
qualified as an expert in financial economics. He has been a professor of finance
and economics at several U.S. universities. He taught Ph.D.-level courses in Brazil in 1983. His considerable
work experience in finance included working as an advisor to Brazil's Rio de Janeiro stock exchange.
[89] Dr. Hoag's mandate
was to analyze the financial aspect of CMRA and CMRA 2, and, in particular, the
value of the notes on the date that they were signed. In his reports,
he found that the value of the notes upon their issuance was nil. He also
prepared a rebuttal to Mr. Williamson's report, entitled "The Reasonableness
of a Decision to Incur a Long-Term Liability in Brazilian Cruzeiros in 1985‑1986."
[90] The relevant facts to
which Dr. Hoag referred were the lack of monetary indexation clauses to
offset the devaluation of Brazil's currency, the interest rates and the currency
in which the notes were denominated (CMRA: cruzeiros at 11.5%; and CMRA 2:
cruzados at 11%) and the fact that interest was not compound, which reduced the
value of the notes to the holder.
[91] The witness reviewed
the methods ordinarily used with various types of financial loans, and applied one
of them. He stated that all these methods should yield more or less similar
results. In addition, he said that business practices in Brazil were adapted to
inflation; financial agents had developed several practices to counter the
effects of inflation, namely:
·
The simplest
method for short-term transactions (less than three months) was to guess what
inflation would be on the date that the contractual obligations were undertaken,
and make adjustments accordingly.
·
In
most international transactions, obligations would be expressly stated to be in
a stable foreign currency such as the U.S. dollar.
·
Where
bank interest was involved, the banks added a certain percentage to the
exchange rate (e.g. the U.S. dollar exchange rate) in effect during the month
in order to take into account the interest earned.
·
For
the prices of certain specific products and services, the Brazilian government
implemented price indexation tables starting in 1950.
·
As
for notes, the witness asserted that they are ALWAYS indexed in Brazil. They were indexed according
to the exchange rate for a given foreign currency or according to an official
price index, depending on the sector to which the promissory notes related.
[92] The witness asserted
that, in Brazil, three-month transactions are considered short-term
transactions, three- to six-month transactions are considered medium‑term,
and those longer than six months are considered long-term. In the case of
long-term transactions, the witness stated, the monetary obligations stipulated
in the agreements normally include mechanisms for monetary correction or
indexation by reference to a foreign currency.
[93] As for interest
rates, the Brazilian government rate in late 1985 was 250% for deposits up to
three months, as compared to 7-9% in North America. After the introduction of the
cruzado in 1986, government interest rates plunged from 300% to 25%, but climbed
back to 110% in January of the following year. In the market, short-term
lenders' interest rates were 25 to 30% higher than the government rate. The
witness noted that, in Brazil, from 1985 to January 1987, there were no short- or
long-term loans on which the interest rate was lower than 50%. In 1985, the
market interest rates varied from 250 to 275% for short-term loans and in 1986,
they ranged from 55 to 60% for such loans. The witness added that he had
not seen any ten-year loans during that period. Ten-year loans were not
standard business practice, especially if they did not have an indexation
formula to counter inflation. He cited the following reasons for this:
1. Inflation
caused a continuous loss of value.
2. Inflation
bit into the interest that the lender expected to earn.
3. Indexation
was a form of protection against inflation.
[94] With respect to the
indexation of interest rates, the witness stated:
The Brazilians, those clever people,
developed a mechanism in all their financial contracts to hedge against
inflation. It was a free hedge, everyone wrote it into their contracts. The one
that didn't is the one that lost in that transaction.
[95] Of all the Brazilian
contracts that the witness studied over the years, the CMRA and CMRA 2 research
contracts were the only ones without a monetary indexation clause.
[96] I found Dr. Hoag’s
testimony to be the most credible, relevant and impartial. Given the data collected
with regard to the issue of the depreciation of Brazil's currency, it is difficult to
believe that the Appellants would not have known in 1985 and 1986 that the
currency would depreciate to such an extent that it would cost them nothing to
pay their notes seven to ten years later. In my opinion, it was easy to
predict that hyperinflation would continue, along with the depreciation of Brazil's currency.
[97] However, it must be
asked whether the fact that it was easy to predict in 1985 and 1986 that the
Brazilian currency would have depreciated seven to ten years later made the payment
under the notes an uncertain future event. In my opinion, the nature of the
obligation was to pay an amount in Brazilian currency starting in 1992. The
amount of money, whatever it was, had to be paid and that was not uncertain. What
was uncertain was rather the amount that the Appellants would have to pay on
maturity, not the actual obligation, and thus, the obligation was not a
contingent liability.
[98] Alternatively, the
Respondent argues that CMRA and CMRA 2 did not present their earnings in a
manner that provided the most accurate picture of their affairs, in accordance
with then-prevailing GAAP.
[99] Doug Cameron worked
as an accountant for the firm of Clarkson Gordon in the 1980s. He was
responsible for auditing CMRA's financial statements as at
December 31, 1985. However, his firm refused to work on CMRA's tax
files. In fact, it expressed the opinion that it would not recommend to its
clients that they invest in CMRA unless they were prepared to face assessments
by Revenue Canada (Exhibit R‑40, Tab I‑33).
[100] The document at Tab I‑50
of Exhibit R‑40 contains the audited financial statements of CMRA as at
December 31, 1985. The C$70 million expense is entered therein as a
scientific research expense; it consists of the $14 million payable immediately
and the $56 million payable in the form of notes denominated in Brazilian
cruzeiros. The exchange rate utilized to arrive at the C$56 million was the
rate in effect on December 31, 1985.
[101] In 1986, CMRA 2 called
upon Clarkson Gordon once again, this time for an accounting opinion regarding the
sale of CMRA 2's partnership shares. The witness said that this was when
his firm realized that the 11% interest rate was clearly insufficient because
the debts were payable in Brazilian currency. The firm had therefore overstated
the value of the research expenses and the value of the notes in the financial
statements that it had prepared. The witness stated:
In particular, we were concerned that the notes payable
denominated in cruzeiros
bore an interest rate of approximately 11%, as I recall. However, we became
aware very shortly after issuing this report that the normal rate of interest
that one would incur in order to ... upon a cruzeiros-denominated obligation,
would be many multiples of 11%.
The consequence of that was
that we felt that the value of the notes was overstated in these financial
statements, the value of the notes and the research expense was overstated in
these financial statements by a significant amount.
[102] The letter of February
27, 1986 (Exhibit R-40, Tab I-246) actually expresses this concern, and reveals
that Clarkson Gordon had just learned that the standard interest rate for a
three-month loan in Brazil was already 225%. The firm was thus very concerned about
the fact that CMRA and CMRA 2's financial statements were not consistent
with GAAP. In fact, Clarkson Gordon obtained from the accounting firm of
Peat Marwick an opinion that the financial statements were incorrect and that
the value of the notes should be lowered in order to take account of the inadequate
interest rate. In subsequent correspondence (Exhibit R‑40, Tab I‑294),
the witness Cameron wrote that the research expenses that his firm had taken
into account in Canadian dollars in the 1985 financial statements did not accurately
reflect the real value of the transaction. On March 14, 1986, Clarkson Gordon withdrew
CMRA's financial statements as at December 31, 1985.
[103] This resulted, at
trial, in what I would characterize as a war between two accounting experts
with respect to the GAAP applicable to CMRA and CMRA 2's financial
statements at the relevant time.
[104] Denis Hérard testified
for the Appellants on this subject. He has been an accountant for 23 years
and was qualified as an expert on auditing. His mandate was in fact to prepare
a rebuttal to the accounting opinion of Allan Wiener, the Respondent's
expert. The two questions that he considered were as follows: [TRANSLATION]
"In what amount — and thus, on what basis of valuation — should the research
and development expenses be entered in CMRA and CMRA 2's financial
statements, and how should the conversion into Canadian dollars of the notes in
question, and of the notes receivable denominated in Brazilian currency, be
accounted for?"
[105] According to Mr. Hérard,
the GAAP at the time called for the use of the original cost, not the present
value, of the SR&ED expenses, in the sense that the value should not be
discounted. The original cost was defined as the amount paid out on the date
that the contract was signed. Thus, in his view, CMRA and CMRA 2's sole
obligation was to use the original cost as the measurement of the SR&ED
expenses. However, Mr. Hérard did not attempt to determine the original
cost of the notes. He was content to use the amounts shown in the partnerships'
audited financial statements. In his opinion, the amounts in question were
payable, or were to become payable, upon the signing of the contracts.
[106] As for accounting for
the conversion of the notes into Canadian dollars, he stated that, in a highly
inflationary economy, the GAAP suggest using the temporal method, in which the basis
of valuation of the notes is established in Canadian dollars and the conversion
into that currency is to be done at the exchange rate in effect on the closing
date of each financial statement. He went on to state that the current exchange
rate method is only recommended where independent foreign entities are
involved, which is not the case with CMRA and CMRA 2. Mr. Hérard
concluded as follows:
[TRANSLATION]
. . . in the present case, the gain
resulting from the conversion into Canadian dollars, in 1985 and 1986, of the
note payable in Brazilian currency was to be amortized over a 7-10 year period,
which was the term of the note. The loss resulting from the conversion into
Canadian dollars, in 1985 and 1986, of the note receivable in
Brazilian currency was likewise to be amortized over a 7-10 year period, which
was the term of the note receivable. Since the amount of the note payable was
exactly the same as the amount of the note receivable, the gain resulting from
the conversion of the note was exactly equal to the loss resulting from the
conversion of the note receivable. Thus, there was no gain or loss on
conversion of currency to be amortized. And that is exactly what was done in
CMRA and CMRA-2's financial statements. [p. 220 - p. 537]
[107] He concludes that the
financial statements of CMRA and CMRA 2 as at December 31, 1985 and
December 31, 1986 are consistent with the GAAP applicable at that
time.
[108] On cross-examination, Mr.
Hérard said that he was not aware that Clarkson Gordon had withdrawn the audited
financial statements which he had used in preparing his report. He had assumed,
without making any further inquiry, that the SR&ED expenses reported in the
financial statements had been based on the original cost. In his opinion, they
reflected the original cost because it was indicated in the financial
statements that they had been prepared in accordance with Canadian GAAP and there
was no note stating that other valuation principles had been used. Moreover, the
witness did not consider whether the promissory notes in question complied with
standard business practices.
[109] The Respondent, for
her part, called Allan Wiener as a witness. He has been an accountant
since 1966 and is a member of the Canadian, Quebec and Ontario institutes of chartered accountants.
He has supervised the publication of a number of articles on accounting. He was
asked for his opinion on the relevant GAAP applicable to the SR&ED expenses
taken into account in CMRA and CMRA 2's financial statements for 1985 and
1986. He specified that the research expenses must be determined according to
their original cost, which must be ascertained in accordance with GAAP and on
the basis of the consideration paid by CMRA and CMRA 2 to Coral, since it
consists of deferred payments, to be made seven to ten years in the future, in
Brazilian currency, plus simple interest at 11% and 11.5%.
[110] The witness noted that
the GAAP that he applied in his report were those in effect in 1985 and 1986.
Since the CICA Handbook was silent as to how to enter deferred-payment
transactions, the witness consulted certain publications, notably one by the
American Ross M. Skinner, entitled "Accounting Principles:
A Canadian Viewpoint" (1972), the relevant excerpt from which is at page
48:
In transactions where
payment is not called for within a short period of time after performance it is
clear that fair measurement of the amount of the transaction requires that the
payments provided for under the contract be discounted, unless a reasonable
rate of interest is provided for in the contract. [emphasis added by author].
Thus, while this concept of
discounting delayed payment transactions is obviously economically sound, it
has complications in practice. Since most business transactions do not involve
abnormal payment delays there may be a tendency in practice to ignore the
discount factor implicit in the occasional transactions involving delayed
payments.
The error in this has
recently been recognized in APB Opinion No. 21, entitled "Interest on
Receivables and Payables".
In Canada, there has been no equivalent official recommendation. In its absence,
occasional examples may be encountered of delayed payment amounts being
recorded of face value rather than fair value. The practice, however, should no
longer be regarded as generally accepted.
[111] According to the
witness, these comments apply to Canadian GAAP even though the publication is
American.
[112] The witness continued
his testimony by reiterating that in order to determine the cost of the SR&ED,
one had to look at the consideration paid for the SR&ED, having regard to
the interest rate. More specifically, what must be determined is whether the
interest rates stipulated in the notes in question were reasonable under the
circumstances. In order to make this determination, the witness said, one
must first consider the compensation paid to Coral for the use of its money. In
other words, he would seek to analyze what fair and adequate compensation would
be.
[113] To do this, the
witness relied on the report of Dr. Cline, who testified that the interest rate
on short-term loans rose from 200% in December 1985 to 355% in January
1986. However, in his opinion, an interest rate of 175% is more conservative,
and more faithfully reflects fair and adequate compensation for the notes
issued by CMRA. He used a rate of 160% for CMRA 2.
[114] Exhibits R‑46 and
R‑47 compare compound interest at 175% and simple interest at 11.5%. The
two tables show that with compound interest at 175% the promissory notes attain
their true theoretical value upon maturity.
[115] Accordingly, the
witness was of the opinion that CMRA's financial statements as at December 31, 1985
should only have reported overall research costs of approximately C$14,034,157,
not C$70,000,000. The amount of $14,034,157 consists of the 20% of the research
costs that the CMRA partners paid in cash in 1985, plus the value of the notes,
which, at maturity, would have been $34,062 according to the witness's
assessment using a discount rate of 175%.
[116] A similar calculation
was done for CMRA 2's financial statements. Its statements should have shown
overall research costs of C$14,707,926, consisting of $14,654,404, which comprises
the 20% plus a balance of $53,522, representing the value of the notes at
maturity when the discount rate of 160% is applied.
[117] On cross-examination,
the witness reiterated that in cases where the CICA Handbook was silent, it was
accepted practice at the time to rely on American accounting practices and
standards. He noted that, according to Skinner, payments with a long-term due
date were to be discounted unless reasonable interest rates were stipulated.
[118] Mr. Weiner also stated
that, according to excerpts from the Mercantile Gazette, the interest
rates were known at the time, and it would have been easy for CMRA, CMRA 2 and
Coral to stipulate a much more reasonable interest rate.
[119] On analyzing all the
circumstances surrounding the financial statements, it is very clear to me
that the amounts used and entered in CMRA and CMRA 2's financial statements do
not reflect the real amount that they invested in the research. In light of the
evidence as a whole, the notes that CMRA and CMRA 2 issued are worth
much less than the amounts entered, due to the use of the hyperinflationary
Brazilian currency and an unreasonable interest rate. I agree with the expert
Mr. Weiner's finding that where the payment is deferred and the interest rate
is not reasonable, one simply cannot claim that the amount in the contract
corresponds to the historical or original cost and enter the amount in the
financial statements on that basis.
[120] I also accept Mr.
Weiner's view that the original or historical cost does not exclude the idea of
"fair value". Here, the price paid was not all in cash (given the
notes that were issued) and the research in question had no known commercial
value, so it was necessary to determine the fair value of the consideration in
order to determine cost.
[121] In my opinion, CMRA
and CMRA 2's financial statements were not prepared in accordance with the
GAAP applicable at the time. I accept Mr. Weiner's testimony as the most
plausible under the circumstances. In the case at bar, one needed to do more
than simply enter the unaudited original cost of the notes. I agree that in
cases where the CICA Handbook was silent, it was reasonable at that time to
rely on American accounting standards and practices to fill the void and that, given
the situation in the present case, one had to discount the value of the
payments with a long-term due date unless the interest rates stipulated were
reasonable, which they were not in the instant case.
Question 2B
Section
67 of the Act
[122] We must now consider
whether the SR&ED expenses claimed by the Appellants were reasonable within
the meaning of section 67 of the Act. In the relevant taxation years,
that provision read as follows:
Section 67: General limitation
re expenses
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.
[123] In Hammill v.
Canada, [2005] F.C.J. No. 1197, the Federal Court of Appeal provided further
explanation concerning the consequences of the application of section 67
where an expense is held not to be reasonable. The relevant part of the
judgment reads as follows:
49 The appellant
points out that this provision contemplates an outlay or expense that has been
incurred for the purpose of earning income within the meaning of paragraph
18(1)(a), and allows the Minister to disallow that part of the
expenditure which can be shown to be unreasonable. In other words, the
provision does not allow for a qualitative review of the expenditure since the
expenditure must have been made to earn income to begin with. What is
contemplated is a quantitative review of the expenditure.
50 Indeed, the judicial
pronouncements on section 67 to date have treated the issue arising under that
provision as one of magnitude or quantum (see Mohamad, supra; Garbco
Ltd. v. M.N.R., 68 DTC 5210). The appellant submits that the following
passage from Vern Krishna, The Fundamentals of Canadian Income Tax, 3rd
edition, properly illustrates the scope and purpose of section 67
(page 312):
The word "reasonable" [in section 67]
would appear to relate primarily to the size or the amount of the deductions
claimed or quantified and not to the type of the expense. "The purpose of
the rule is to prevent taxpayers from artificially reducing income by deducting
inordinately high expenses", ...
51 I agree that
this statement accurately reflects how section 67 has been applied by the
courts to date. However, the Supreme Court in Stewart, supra,
commented on the application of section 67 and signalled that it could have a
broader application. It will be recalled that in Stewart, the
Supreme Court dealt away with the "reasonable expectation of profit"
test as a means of ascertaining the existence of a source of income. The Court
recognized that this test had been devised to counter abuses, but held that it
had no statutory foundation and created more problems than it resolved.
52 In devising the
"recommended approach", the Supreme Court identified section 67 as
the statutory means of controlling excessive or unwarranted expenditures once a
source of income is found to exist. It said at paragraph 57:
... If the deductibility of a particular expense
is in question, then it is not the existence of a source of income which ought
to be questioned, but the relationship between that expense and the source to
which it is purported to relate. The fact that an expense is found to be a
personal or living expense does not affect the characterization of the source
of income to which the taxpayer attempts to allocate the expense, it simply
means that the expense cannot be attributed to the source of income in
question. As well, if, in the circumstances, the expense is unreasonable in
relation to the source of income, then s. 67 of the Act provides a
mechanism to reduce or eliminate the amount of the expense. Again,
however, excessive or unreasonable expenses have no bearing on the
characterization of a particular activity as a source of income. [emphasis added]
53 The choice of words (reduce or
eliminate) is not accidental. The Supreme Court was setting-up [sic]
section 67 as the proper means of testing the reasonableness of an expense once
a business has been found to exist. It was doing so after having explained
that at the first level of inquiry (i.e. the existence of a source of income
and the relationship between an expense and that source) courts ought not to
second guess the business judgment of the taxpayer (Stewart, supra,
paragraphs 55, 56 and 57). Section 67 was identified as the statutory authority
pursuant to which an inquiry could be made as to the reasonableness of an
expense. In my view, the Supreme Court in Stewart acknowledged that
there is no inherent limit to the application of section 67, and that in the
appropriate circumstances, it can be used to deny the whole of an expense, if
it is shown to be unreasonable.
54 In
this case, the Tax Court Judge attempted to identify what part of the
"selling" expenses could be viewed as reasonable in the
circumstances. He noted that neither counsel could indicate any cut off point.
He went on the hold that the actions of the appellant were the same throughout
and concluded that the expenditures were unreasonable from beginning to end. In
my view, this is a conclusion that was open to him why [sic] regard is
had to the evidence.
[Emphasis
added.]
[124] The same decision lays
down the principle that if it is held that the expenses claimed by the
appellants are unreasonable under the circumstances, the expenses are to be disallowed
in their entirety.
[125] It must also be remembered
that, in determining whether an expense is reasonable, one must be careful not
to substitute one's own judgment for the business judgment of the parties, as
the Federal Court of Appeal cautioned in Keeping v. Queen, [2001] F.C.J.
No. 899. The relevant passage from that decision is as follows:
5 With respect, I am of the
opinion that the analysis conducted by the Tax Court Judge amounted to
second-guessing the business acumen of the appellant which is not the place of
the Courts. As stated in Mastri v. Canada (Attorney General), [1998] 1 F.C. 66 (C.A.),
at paragraph 12:
In summary, the decision of this Court in Tonn
does not purport to alter the law as stated in Moldowan. Tonn simply
affirms the common-sense understanding that it is not the place of the courts
to second-guess the business acumen of a taxpayer whose commercial venture
turns out to be less profitable than anticipated.
In basing his decision on profit
margins, potential market opportunities and costs, as well as the appellant's
approach to operating his distributorship, the Tax Court Judge was second-guessing
the business acumen of the appellant. In doing so, the Tax Court Judge erred in
law.
[Emphasis added.]
[126] The test under
consideration in Keeping was reasonable expectation of profit. The
Appellants point out, however, that, in Ankrah v. The Queen,
[2003] T.C.J. 422, Justice Woods of this Court held that the above comments could
equally be applied to the test of the reasonableness of an expense. Justice
Woods stated in that regard:
Section 67
32 The Crown
submits that it was unreasonable for Mr. Ankrah to incur large
expenditures after the business had incurred losses for several years. It was
suggested that instead of spending large sums of money on recruits, the same
result could have been achieved by personal training.
33 The
difficulty with the Crown's position is that supplants the business judgment of
the taxpayer. Mr. Justice Rothstein commented on this in another Amway case, Keeping
v. R., [2001] 3 C.T.C. 120 (F.C.A.), at paragraph 5:
With respect, I am of the opinion that the
analysis conducted by the Tax Court Judge, [1999] T.C.J. No. 277,
amounted to second-guessing the business acumen of the appellant which is not
the place of the Courts. As stated in Mastri v. R. (1997), [1998] 1 F.C. 66 (Fed.
C.A.), at paragraph 12:
In summary, the decision of this Court in Tonn
does not purport to alter the law as stated in Moldowan. Tonn
simply affirms the common-sense understanding that it is not the place of the
courts to second-guess the business acumen of a taxpayer whose commercial
venture turns out to be less profitable than anticipated.
In basing his decision on profit margins,
potential market opportunities and costs, as well as the appellant's approach
to operating his distributorship, the Tax Court Judge was second-guessing the
business acumen of the appellant. In doing so, the Tax Court Judge erred in
law.
This comment was made in
the context of the REOP doctrine but I see no reason why it should not also
apply in the context of section 67.
34 The phrase
in section 67 "reasonable in the circumstances" is broad but I do not
believe that it should apply to reduce expenses based on poor business
judgment. Section 67 is commonly applied to reduce the quantum of expenses in
cases where the taxpayer is motivated partly by something other than business
reasons, such as a payment of salaries to family members. This was described by
Mr. Justice Cattanach in the case of Gabco Limited v. M.N.R.,
68 D.T.C. 5210 (Ex. Ct.) at page 5216 as follows:
It is not a question of the
Minister or this Court substituting its judgment for what is a reasonable
amount to pay, but rather a case of the Minister or the Court coming to the
conclusion that no reasonable business man would have contracted to pay such
an amount having only the business consideration of the appellant in mind.
35 Mr. Ankrah
arguably has exercised bad judgment in incurring these expenses. However, the
expenses were incurred with an honest belief that they would eventually lead to
profits and I do not believe that section 67 should be applied in these
circumstances.
36 Mr. Ankrah
has incurred significant losses from the Amway distributorship over many years.
If the deduction of those losses is not an appropriate tax result, it is a
matter for Parliament to address. I note that section 31 of the Act was
enacted in 1988 to address a concern with farming losses.
[Emphasis added.]
[127] In Safety Boss Ltd.
v. Canada, [2000] T.C.J. No. 18, Judge Bowman (as he then was) relied on an
excerpt from the decision of Justice Cattanach in Gabco Ltd. v. M.N.R.
with respect to the criteria to be applied in deciding whether an expense is
reasonable having regard to the circumstances. At paragraph 52, Judge
Bowman stated:
52 There have been numerous cases
on the question of the reasonableness of expenses. Essentially the
determination is one of fact. I shall refer to only one that sets out the
principle and that has been frequently cited: Gabco Ltd. v. M.N.R.,
68 DTC 5210. At page 5216 Cattanach J. said:
It is not a question of the Minister or this
Court substituting its judgment for what is a reasonable amount to pay, but
rather a case of the Minister or the Court coming to the conclusion that no
reasonable business man would have contracted to pay such an amount having only
the business consideration of the appellant in mind. I do not think that in
making the arrangement he did with his brother Robert that Jules would be
restricted to the consideration of the service of Robert to the appellant in his
first three months of employment being strictly commensurate with the pay he
would receive. I do think that Jules was entitled to have other considerations
present in his mind at the time of Robert's engagement such as future benefits
to the appellant which he obviously did.
[Emphasis added.]
[128] Thus, the question in
the case at bar is whether a businessperson would have contracted to pay Coral
$1.75 million per monoclonal antibody having only the business interests of the
CMRA and CMRA 2 partners in mind. As Judge Bowman noted, this is a
question of fact.
[129] The Appellants'
evidence on this issue consists essentially of the testimony of their expert
witness Dr. Pradip Banerjee, presented in the report by P.A. Consulting Group.
The Appellants submit that if the Court decides to second‑guess the
Appellants' business decisions, it will be running counter to the well-settled
case law principle that neither the Respondent nor the Court should substitute
its own judgment for business decisions made by taxpayers.
[130] I agree that the case
law encourages caution, as opposed to the total rejection of an assessment of
whether an expense is reasonable. If the Minister were submitting that the
expense could have been avoided through some other measure, as was the case in Ankrah,
then he would be attempting to substitute his own judgment for that of the
Appellants. However, in the case at bar, the Minister submits that the
expense was not reasonable having regard to the circumstances. In my opinion,
he is not thereby trying to substitute his judgment for that of the Appellants.
[131] The Respondent submits
that for the following reasons the expense was unreasonable having regard to
the circumstances:
1. The evidence showed
that a few of the antibodies produced were later sold for an average of $700,000
each.
2. No valid
comparability study was done to prove that $1.75 million was a reasonable price
to pay.
3. When Dr. Gold testified
that the costs of producing human monoclonal antibodies are
"limitless" he was not doing so as an expert witness and he
acknowledged that he had no expertise in the field of monoclonal antibodies.
4. The fact that only
20% of the price was paid when the research began and that it was used for the
research raises doubts about the 80% balance.
5. The contract
provided that Coral was to work on 57 projects, but the number was reduced to
40 without any adjustment to the total price.
[132] The Respondent also pointed
to the fact that CMRA did not have ownership of the cell lines under its
contract with Coral. However, the contract was amended in order to eliminate
this anomaly when it came to the Appellants' attention. I do not believe that this
anomaly is an important factor in the present analysis.
[133] The Appellants' expert
witness on this issue holds a doctorate in pharmaceutical sciences and an
M.B.A. The Appellants mandated him to prepare an expert report looking at two
very specific questions: whether the price paid by the Appellants for the
research on antibodies was reasonable or not, and whether such research could
have been done in Canada. With regard to the second question, he concluded that CMRA and
CMRA 2 had no choice but to have their research done outside Canada owing to a lack of
funding and resources in Canada.
[134] The witness prepared a
report for each partnership. In his testimony, he said that he had assessed the
reasonableness of the investment, not the reasonableness of the production
costs, and that this is why he concluded that the expense was reasonable under
the circumstances. He also stated that the price paid was reasonable because a
purchaser is always prepared to pay more than the actual cost for such an
innovative project, since the purchaser can hope to carry out many other projects
thereafter.
[135] The witness also
relied on the fact that the Appellants had had very thorough verifications done
before investing. He relied as well on the report by Fritzsche Pambianchi in
stating that the price asked by Coral was not unreasonable. According to the
antibodies market assessment report, that market was promising. Using similar
partnerships for comparison, he arrived at a price of $1.24 million per
antibody, and at the price of $1.7 million using the price-profit ratio method.
[136] However, the
cross-examination of this witness disclosed the following:
1. The
average cost to develop a monoclonal antibody to the point of production of a
marketable diagnostic kit is in the range of $640,000 to $1,330,000 and the
cost of developing the antibody itself is only one-third of the total cost.
2. The
price of $1.75 million paid by CMRA and CMRA 2 was much higher than the actual
cost of developing the antibodies.
3. The
evidence that he used points of comparison to assess the reasonableness of the
expense is not conclusive, so the results of the comparison are questionable.
4. There
were no data from the financial statements and no specifics regarding the CMRA
and CMRA 2 scientific projects.
5.
The evaluation
by the firm of Fritzsche Pambianchi (Tab 6, Exhibit A‑5) bears
a date that is subsequent to his report. One wonders, then, how the witness could
have based his assessment of the reasonableness of the price paid to Coral on
an evaluation that did not yet exist.
6.
On page
8 of the Fritzsche Pambianchi evaluation it is stated that the evaluation was
intended only to be a pro forma evaluation without any legal impact on the cost
of developing the products. According to the report, each cell line cost
between $30,000 and $50,000 to develop.
[137] The Respondent, for
her part, submits that the cost was not reasonable at the time of the audit,
basing that contention on the estimate done by a team of experts assembled by
Wayne Kirkey, a tax avoidance case coordinator with Revenue Canada at the time.
Mr. Kirkey had brought together three biotechnology experts to look into the
CMRA research projects, and, according to their monoclonal antibody production
cost estimates, an average cost of $62,000 per project was to be expected. As for
the CMRA 2 research projects, the group of experts determined the
figure to be $138,000 per project.
[138] The experts Kennett,
Brodeur and Norgard testified with regard thereto at the hearing. What
emerges from their testimony is that one must also take the production costs
and profit margin into account — that is to say, the commercial
value of the product as well as the production costs — in determining whether
the expense is reasonable. Dr. Kennett is one of those who admit to
taking the profit margin into account with regard to costs for research projects.
He concluded that the price of $1.7 million paid for each research project was
unreasonable because, in his view, each project could have been carried out for
between $55,000 and $75,000, including all direct and indirect costs. He added
that in 1985 his university could have produced any of the monoclonal
antibodies in question for $45,000 each, and that when so many research
projects are being carried on at the same time, each project costs less than would
normally be the case because the protocols are repeated, resulting in lower
production costs.
[139] Lastly, the expert
witness Dr. Kennett submitted a rebuttal report in response to the report of Dr. Banerjee
and his group, PA Consulting Group. He criticized that report for not having
considered the utility of the monoclonal antibodies, their raison d’être, why
they were needed, and their practical application. He added that the report did
not provide a breakdown of the numbers on which those experts relied. In his
opinion, the development of the antibodies represents in fact only 10% of the
cost of producing a test kit, and he concluded, as stated above, that the
amount of $1.7 million is unreasonable under the circumstances.
[140] As for Dr. Brodeur,
he stated that the costs were not correctly determined, for the simple reason
that they did not take into account the number of hours spent on each project
or the resources utilized for each of the projects, which were very different. This
tends to confirm the position that, instead of being based on actual production
costs, the prices were set without regard to the nature of the antibodies in
question or the value of the work.
[141] In his rebuttal to Dr.
Banerjee's report, Dr. Norgard states that Dr. Banerjee's report is too
vague and is flawed because it does not take account of several elements such
as the need for, and the utility, raison d’être and practical application of,
the monoclonal antibodies. He is also in disagreement regarding the concepts of
"niche products", "speed to market" and "delivery
systems" put forward by Dr. Banerjee, because he does not believe that
there will be a viable market for the products developed by Coral. Furthermore,
he rejects Dr. Banerjee’s potential sales projections for the antibodies. The
other points that Dr. Norgard disputes can be summarized as follows:
1. The
figures that Dr. Banerjee uses for the purpose of cost comparisons with other
similar businesses are meaningless because they are not broken down.
2. With
regard to the test kits, the costs associated with research on antibodies generally
represent only 10% of the total cost of putting a kit on the market, not the
30% that Dr. Banerjee indicates in his report.
3. The estimate of $1.7 million for research on
each monoclonal antibody is an overestimate because that is not the cost of the
work that was truly necessary; moreover, the same antibodies, of better
quality, cost only a fraction of the price of Coral's. For example, the witness
refers to the University of Texas Southwestern Medical Center, where he works
and where a monoclonal antibody can be produced for as little as $3,400 on cell
lines of 20 to 30 species.
[142] In view of these
considerations, I can only conclude that the evidence does not support the
Appellants' argument that the price paid in the case at bar was reasonable
having regard to the circumstances. In my opinion, the Appellants have not discharged
their onus of proof. Their expert's evidence was greatly discredited by the
Respondent's experts and by his own testimony on cross-examination.
[143] It is impossible to
conclude in the present case that a businessperson would have embarked on such
a project without the assurance that the actual cost of his or her involvement
would be limited to his or her initial outlay, namely 20% of the price of CMRA
and CMRA 2's contracts with Coral. In my opinion, none of the Appellants
expected to pay anything more than that initial outlay. In my opinion, there
was never any question of the research costs actually exceeding the initial outlay.
Thus, I cannot conclude that the price was reasonable under the
circumstances, and I must therefore disallow in their entirety the expenses
incurred by the Appellants.
Subsection 245(1) of
the Act
[144] My above-stated conclusion
is sufficient to dispose of the instant appeals; however, I will consider
whether these deductions, if allowed, would unduly or artificially reduce the
Appellants' income within the meaning of subsection 245(1) of the Act,
which read as follows at the relevant time:
245(1) Artificial
transactions
(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.
[145] The relevant factors
in assessing whether the deductions claimed by CMRA and CMRA 2 did in fact
unduly or artificially reduce net income were developed by the Federal Court of
Appeal in Canada v. Fording Coal Ltd., [1996] 1 F.C. 518, and reiterated
by that Court in Novopharm Limited v. Canada, 2003 FCA 112, as
follows:
24 The learned Tax Court
Judge had regard to the factors established by this Court in Canada v.
Fording Coal Ltd. (C.A.), [1996] 1 F.C. 518 and adopted in Canada v.
Central Supply Company (1972) Ltd. (C.A.), [1997] 3 F.C. 674, in
assessing whether Novopharm's deductions unduly or artificially reduced income
for purposes of subsection 245(1). The factors are:
1. would the deduction, if
permitted, be contrary to the object and spirit of the Income Tax Act;
2. are the transactions giving rise
to the deductions made in accordance with normal business practice; and
3. were the transactions
entered into for bona fide business purposes?
Applying the Fording
approach, the Tax Court Judge concluded that Novopharm's appeal failed under
subsection 245(1).
[146] In Ludco Enterprises
Ltd. v. Canada, [1999] F.C.J. No. 402, the Federal Court of Appeal
considered the application of former subsection 245(1) of the Act in the
following terms:
Does subsection 245(1) of the Act apply
to the appellants because they may have incurred expenses in an operation that
unduly or artificially reduced their income?
104 The respondent argues that the interest
deductions the appellants claimed for their investments in Justinian and
Augustus artificially reduced their income. At the time, the applicable
provision read:
S. 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.
Art. 245. (1) Dans le calcul
du revenu aux fins de la présente loi, aucune déduction ne peut être faite à
l'égard d'un débours fait ou d'une dépense faite ou engagée, relativement à une
affaire ou opération qui, si elle était permise, réduirait indûment ou de façon
factice le revenu.
105 In my view, the respondent's argument is unsound.
As this Court mentioned in Canada v. Fording Coal Ltd., the undue or
artificial nature of the reduction of income is what has to be examined, not
the artificiality of the transaction with which the expense is associated.
In this regard, incidentally, there was nothing artificial about the
transaction as such, and the parties agree on that.
106 According to the case law, there are three
factors involved in the application of subsection 245(1), and I am of the view
that the deduction the appellants claimed comes within the parameters of those
three factors.
107 First, the interest deduction is in keeping with
the object and spirit of subparagraph 20(1)(c)(i), which as I
have already mentioned, relates to the acquisition of capital with a view to
earning income therefrom.
108 Second, the loan the appellants took out is in
accordance with normal business practice relating to the acquisition of
shares or debt securities. In fact, it often happens that the purchase of these
assets by taxpayers is financed by bank loans and the assets given as security.
For example, every year at this time, one need only observe the frenzy
surrounding investment in registered retirement savings plans and the
advertising about the financing available for that purpose. This is an
incentive Parliament intended to provide.
109 Third, the loan the appellants took out had a bona fide
business purpose. In fact, the borrowed amounts were used to purchase
shares in Justinian and Augustus corporations. These companies generated profits
and, as is often the case in such matters, they in part distributed those
profits in the form of dividends to their shareholders and in part capitalized
those profits. The evidence shows that the dividends the appellants received
were within the range of dividend amounts paid by Canadian companies listed on
the Toronto Stock Exchange. (I note that a number of companies pay dividends of
less than 1% and that well-established companies at the time were not paying or
for a time did not pay any dividends. For example, the evidence shows that
Can-Am Manac has not paid any dividends since 1991 and that MacKenzie Financial
Corporation paid its first dividends after 18 years in operation, which Cascade
has never done since being created over 30 years ago, despite having sales of
$2.27 billion.)
[Emphasis added.]
[147] It is therefore
important to answer the three questions formulated in the case law in order to
determine whether the consequences referred to in subsection 245(1) would
exist in the case at bar. I would note that the fundamental principle is that a
taxpayer may organize his affairs in such a manner as to pay the least tax
possible, as the Federal Court of Appeal held in Ludco Enterprises Ltd.,
supra:
62 Justinian and Augustus corporations were thus
conceived, and their operations planned, in light of Canadian income tax laws
to allow their shareholders to minimize their payment of taxes owing to Revenue
Canada as a result of their investments. I hasten to add that by
the respondent’s own admission, the tax planning that led to the creation of
these two companies, and their operations, were perfectly lawful, the
transactions that took place were not a sham, the dividends were actually paid
to the appellants and taxed by Revenue Canada and the appellants, being in no
way involved in the management of these companies, dealt with them at arm’s
length. Moreover, it is a well-known principle in Canadian tax law that a
taxpayer may, by taking advantage of the provisions of the Act, arrange his or
her affairs to pay—and with the sole aim of paying—the least amount of income
tax. In
fact, the Revenue Canada Declaration of Taxpayer Rights, a copy of which is on
the back cover of the General Income Tax and Benefit Guide provided to the
taxpayer each year, states:
You are entitled to arrange
your affairs to pay the least amount of tax the law allows.
In short, the
clever plan proposed for Justinian and Augustus shareholders was the result of
lawful legal planning. As a result, however clever and perhaps even irksome to
some, that planning must not colour the legal analysis and interpretation of
the right to deduct interest under subparagraph 20(1)(c)(i) of
the Act.
[Emphasis added.]
[148] Would the deductions,
if allowed, be contrary to the object and spirit of the Act? The object and
spirit of the Act's provisions concerning SR&ED were enunciated by Judge
Bowman (as he then was) in Consoltex Inc. v. Canada, [1997] T.C.J. No. 134,
at paragraph 79:
79 In a case of
this type where complex provisions of the Act are involved there is a danger
that one may become entangled in technicalities and lose sight of the forest by
too minute an examination of the bark on the trees. If one takes a couple of
steps back and seeks to determine what the scientific research provisions of
the Act are designed to accomplish, it is clear that they should be interpreted
in a manner that encourages scientific research in this country. To whittle
away at those provisions defeats that object. It is not, after all, as if a
taxpayer who incurs current scientific research expenses is being given a
double deduction or one that it would not otherwise have. The appellant would
have been able to deduct these expenses even if section 37 did not exist. All
it is getting is the incentive of an investment tax credit. All expenditures,
whether capital or current, that give rise to ITCs are deductible one way or
another in computing income, either currently or over time, and all of them,
one way or another, result, or are intended to result in or the production of
income. It runs counter to the entire philosophy of fiscal incentives,
whether in the form of SR & ED allowances or ITCs, to say that if the
expenditures giving rise to the incentives result, actually or potentially, in
income they should be watered down.
[Emphasis
added.]
[149] Thus, the intent of
the provisions is to encourage taxpayers to invest in research and development.
Do the deductions that have been claimed defeat that purpose or object?
[150] The Respondent submits
that, in the case at bar, no rational objective would be achieved by allowing
the deductions with respect to the notes, that is to say, the $56 million
expense for one partnership and the $58 million expense for the other. Counsel
for the Respondent submit that the structure of these contracts ran counter to
the object of the provisions, because the notes did not serve to finance the
research, since they were only repayable seven to ten years later. In addition,
relying essentially on the experts' testimony, counsel argue that the economic
evidence shows that the deductions claimed did not reflect the actual value of
the notes at the time that they became payable. In other words, the value of
the consideration actually given by the two partnerships, determined on the date
that it was actually quantified, is far less than the amount of the deductions.
[151] For their part, the
Appellants submit that the Respondent would never have jumped to such conclusions
if the notes had been repayable in a foreign currency, in U.S. dollars for
example. They argue that, in any event, if the notes had been kept until
maturity and repaid in valueless Brazilian currency, the Appellants would have
realized a taxable gain on a liability, so the amounts would not have escaped taxation.
They add that it is the Respondent, through her fault and conduct, who is
depriving herself of the amounts that she could have collected as a result of transactions.
[152] Although the
Appellants said that their investment was not motivated by tax benefits, and
that they invested because the research on monoclonal antibodies was an
innovative project at the time, the fact remains that the structure of the
contracts made it impossible for Coral to use the amounts in question for
research to be conducted in 1985 or 1986. In addition, according to the
economic evidence adduced, the value of the consideration paid by CMRA and CMRA
2, determined on the date that it was actually quantified, is far lower than
the amount of the deductions. Thus, there is a clear disproportion between the
actual value of the notes and the amount of the deduction. The absence of an
adjustment clause in case of depreciation of the Brazilian currency is another
relevant factor.
[153] In my opinion,
granting the deductions to the Appellants would run counter to the object and
spirit of the Act under the circumstances. Coral's activities were organized
and conducted so as to give rise to deductions that were excessive,
unreasonable and abnormal, and that were therefore inconsistent with the object
and spirit of the Act, which is to encourage taxpayers to invest in research.
The Appellants set up research projects, but the great majority of the
deductions that they claim have no connection with that research.
[154] One must also ask oneself
whether the transactions with respect to which the deductions were claimed were
carried out in accordance with normal business practice. The Respondent's
experts' testimony is categorical: the promissory notes in issue were not
negotiated in accordance with normal business practice. The main basis for this
assertion is that the simple interest rates of 11% and 11.5% on the notes are
much lower than the interest rates in effect at that time in Brazil, which varied between 50%
and 275% depending on the term of the loan.
[155] According to the
expert witness Dr. Hoag, the Brazilian business community developed a number of
practices to protect itself against the effects of inflation. He said that
promissory notes in Brazil are always indexed to the exchange rate for a given foreign currency or to
an official price index, depending on the sector of the economy in which the
notes are issued. This is particularly the case for long-term transactions. Monetary
liabilities normally include correction formulas. The conclusion that Dr.
Hoag draws from this is that a ten‑year loan, especially one without a
formula for indexation to inflation, was not normal business practice. Indeed,
inflation results in a continuous loss of value, thereby eating into the
interest that the lender expects to earn, and indexation is a means of protecting
against inflation. Dr. Hoag also points out that Brazilian law had provided for
automatic indexation for all contracts in existence upon the coming into effect
of the Cruzado-Plan in January 1986, provided that the contracts contained a
monetary indexation clause. He concludes that no one, at the time, would
have wanted to hold notes of the kind in issue.
[156] With respect to the
promissory notes' lack of an indexation formula, the expert witness Dr.
Cline asserts that this was contrary to business practice at the time, because no
one wanted to run the risk of having their projects go up in smoke due to
inflation. Dr. Cline says as well that the interest rates stipulated in
the promissory notes in the case at bar do not reflect the reality of Brazil's financial market,
which is discussed above.
[157] The Appellants,
through the expert Williamson, maintain that even though the transactions were
not standard practice, parties are not forbidden to be innovative, and the
parties in the case at bar were not bound by standard practice. The question
that I must answer here is precisely whether the transactions, in particular as
regards the terms of the promissory notes, were in accordance with normal
business practice. In my opinion, the Appellants have not succeeded in satisfying
me, on a balance of probabilities, that the terms and structure of the
promissory notes were consistent with normal business practice in 1985 and
1986.
[158] The last question is
whether the transactions in issue had a bona fide business purpose. The
Respondent points out that the value of the notes, namely 80% of the contract
or debt, did not serve to fund the research work, because the notes were only
repayable 7-10 years later, and thus, the promissory notes were not negotiated
for the same business purpose as the contracts between Coral on the one hand
and CMRA and CMRA 2 on the other. Coral had to complete its work by
December 31 of the relevant years.
[159] The Respondent further
contends that the Appellants' argument that a trust was created for the benefit
of the employees, and that the trust was administering Coral's promissory
notes, does not hold water because 80% of the value of the research contract is
too high a percentage, and because, moreover, none of Coral's employees
received any money from the trust.
[160] The Respondent also
argues that there was no bona fide business purpose for using Brazilian
currency, since Coral had no significant activities in Brazil as the research
was being done at a laboratory in England. Why, then, was Brazilian currency
used? The Respondent goes even further, casting doubt on the need to use Brazilian
currency for transactions between the partners and CMRA and CMRA 2.
[161] I accept the
Respondent's arguments and find, on the whole of the evidence, that the
promissory notes in issue had no bona fide business purpose.
Consequently, I am of the opinion that subsection 245(1) should be applied
because the deductions claimed unduly or artificially reduce the Appellants'
income.
[162] For all these reasons,
the appeals are dismissed, with costs.
Signed at Ottawa, Canada, this 30th day of January 2008.
"François Angers"
Translation
certified true
on this 28th day
of May 2010.
Erich Klein, Revisor
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