Date: 20020430
Docket: 2000-3636-IT-G
BETWEEN:
FREDERICK W. HILL,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasonsfor
Judgment
Miller, J.T.C.C.
[1]
This is an appeal by Mr. Frederick Hill of the Minister's
reassessments of his 1996 and 1997 taxation years. Canada Customs
& Revenue Agency ("CCRA") disallowed interest
expenses claimed by Mr. Hill in the amounts of $1,455,089 and
$1,288,612 in 1996 and 1997 respectively, as well as disallowing
the deduction in 1996 of non-capital losses from 1992 and 1993
totalling $631,402.63. The 1992 and 1993 losses also relate to
interest expenses from those years.
[2]
Given the Appellant's reliance in argument on the carefully
drafted Partial Agreed Statement of Facts, it is appropriate to
reproduce those facts as agreed:
1.
The Appellant is an individual, resident in Regina,
Saskatchewan.
2.
On February 18, 1974, the Appellant as to 25%, a company
controlled by the Appellant as to 25% (Regent Realty Ltd. which
changed its name to Harvard Developments Ltd.
("HDL")), and two others as to the remaining 50% (the
"Co-owners"), acquired land in downtown Calgary for
the purpose of building thereon an office building (the
"Project"). Immediately after acquiring the land the
Co-owners sold it to the Trustees of the Post Office
Superannuation Scheme of the United Kingdom ("POSS").
(POSS was replaced by Postel Properties Limited
("Postel"), who in turn leased the land back to the
Co-owner for a term of 99 years.
3.
POSS lent the Co-owners $17,450,000 to erect an office building
on the property, which loan was secured by a mortgage on the
property, also for a term of 99 years.
4.
The relationship between the Co-owners and POSS was set forth in
a Master Agreement, a Mortgage Agreement and a Lease Agreement,
all of which were entered into on February 18, 1974. Taken
together these agreements provided that:
(a)
Interest Expense under the Mortgage escalated from 9% at the
outset to 15% commencing in 2005, and was based on principal and
unpaid interest and was payable monthly.
(b)
The Lease Agreement provided that after the building was
completed, 40.5692% of the cash flow from the project was to go
to the Co-Owners. The remaining 59.4308% of cash flow was defined
as "Balance of net Cash Flow", and was to be paid to
POSS as interest or as rent.
(c)
The Schedule provided:
"The Mortgagors shall pay to the Mortgagee the Interest
Payment on each Payment Date during the Term, PROVIDED, HOWEVER,
if the Interest Expense on any Payment Date exceeds the Balance
of Net Cash Flow payable to the Mortgagee, then the amount of the
said excess shall accrue due and be payable to the
Mortgagee".
(d)
If on any monthly payment date the Balance of Net Cash Flow
exceeded the stated Interest Expense the difference was to be
paid to POSS as rent.
(e)
Payments of principal and unpaid interest were to commence in
1995, and were to be payable over the balance of the term of the
Mortgage with the balance to be paid no later than at the end of
the term of the Mortgage.
5.
During the period 1974-1999, with the exception of the year 1983,
no lease payments were required to be made as the Balance of Net
Cash Flow from the building was not sufficient to trigger lease
payments. In 1983, the Balance of Net Cash Flow for that year
exceeded the Interest Expense by $77,377.
6.
On December 22, 1983, HDL purchased the interests in the lease
and assumed the obligations under the Mortgage of those Co-owners
other than the Appellant, borrowing a further $7,550,000 from
Postel to do so. Accordingly, after the purchase the balance
owing to Postel secured by the Mortgage was:
Balance under existing mortgage
$22,394,889
Borrowing for
purchase
7,550,000
Commission
100,000
$30,044,889
7.
At the same the parties amended the agreements.
(a)
The stated Interest Expense under the Mortgage was changed,
escalating from 13% to 21% for the period commencing in 1995 to
the end of the term.
(b)
The Mortgage Agreement continued to provide for Interest Payments
to be made on monthly Payment Dates as specified in Schedule A to
the Mortgage, but paragraph 2 was amended and paragraph 3 was
added:
"2.
The Mortgagor shall pay to the Mortgagee the Interest Payment on
each Payment Date during the Term, Provided However, if the
Interest Expense on any Payment Date exceeds the Balance of Net
Cash Flow Payable to the Mortgagee, then the amount of said
excess shall accrue due and be payable to the Mortgagee on the
31st day of December in each year. Up to and including
the year 1994, upon payment by the Mortgagor of any excess as
aforesaid, Mortgagor may request in writing from the Mortgagee an
advance of such excess. Mortgagee shall, within thirty (30) days
of such request, advance to the Mortgagor the amount of such
excess requested by Mortgagor, provided that the Principal of the
Mortgage shall never exceed Thirty Five Million Dollars
($35,000,000).
3.
Subject to paragraph 2 above, if the Mortgagor does not pay the
Mortgagee the excess of the Interest Expense on any Payment Date
over the Balance of the net Cash Flow, such excess shall be added
to the balance of the principal and shall bear interest at the
rate stipulated in this Schedule at the relevant
period."
(c)
That same Schedule defined the words "principal" and
"principal payments" as follows:
"‘Principal' means the balance from time to
time of the advances made by Mortgagee to Mortgagor pursuant to
this mortgage, together with any accrued interest due and
payable.
‘Principal Payments' means the amount of the
Principal, together with accrued interest due and payable by the
Mortgagor to the Mortgagee, which said Principal and accrued
interest as aforesaid shall be paid by the Mortgagor to the
Mortgagee by consecutive monthly instalments, the first of such
instalments to be made on the first Payment Date in the twentieth
(20th) year of the Term (as defined in the Lease) and
continuing thereafter during the balance of the Term, and the
balance, if any, on the day preceding the last day of the Term of
the Lease. The amount of each monthly instalment payable
hereunder in any year during the Term shall be a sum which shall
be determined by the application of the following formula:
1/12x 1(X Principal)=monthly instalment in
applicable year
1
where:
X means the number of year before the end of the Term of the
Lease."
(d)
The Lease Agreement was amended to provide that Postel's
portion (the "Balance of Net Cash Flow) became 81.3663% of
cash flow and the Co-owner's portion 18.6337%.
8.
During the period from December 31, 1983 up to November 30, 1995,
the Interest Expense on each Payment Date exceeded the Balance of
Net Cash Flow available for payment, with the result that on
December 29, 1995, the amount of unpaid interest owing by the
Co-owners to Postel was approximately $60,369,999.
9.
On January 1, 1995, the parties further amended the Mortgage
Agreement and Lease Agreement by removing the $35,000,000 maximum
referred to in paragraph 7 above, by reducing the annual Interest
Expense to 10% per annum, and by altering the percentage of net
cash flow such that 90% went to Postel and 10% to the Co-owners.
The newly amended mortgage read:
"2.
The Mortgage shall pay to the Mortgagee the Interest Payment on
each Payment Date during the Term, PROVIDED, HOWEVER, that if the
Interest Expense on any Payment Date exceeds the Balance of the
Net Cash Flow Payable to the Mortgagee, then the amount of the
said excess shall accrue due and be payable to the Mortgagee on
the 31st day of December in each year. Upon the
payment by the Mortgagor of any such excess as aforesaid the
Mortgagor may request in writing from the Mortgagee an advance of
such excess and the Mortgagee shall, forthwith following such
request, advance to the Mortgagor the amount of such excess and
any such amount so advanced shall be added to and included in
Principal."
10.
All other provisions of the Mortgage remained in force.
11.
On or about December 19, 1995:
(a)
HDL (on behalf of itself and the Appellant) borrowed $60,370,000
or 28,816,230 Pounds Sterling from CIBC;
(b)
CIBC paid the 28,816,230 Pounds Sterling to Postel's bank
account at Royal Bank of Scotland on the condition that an
identical amount would be in Postel's account at that bank
with instructions from Postel to be transferred to HDL's
account at CIBC;
(c)
Royal Bank of Scotland transferred 28,816,230 Pounds Sterling to
HDL's bank account at CIBC and Postel was given credit for
the 28,816,230 Pounds Sterling transferred by CIBC; and
(d)
CIBC was paid a financing fee of $50,000.
all of which will be more particularly described at the
hearing of this matter.
12.
In 1992 and 1993 the Appellant's portion of the Interest
Payment exceeded the Balance of Net Cash Flow by $1,526,221 and
$1,817,132 respectively. Those amounts were due and payable on
December 31, 1992 and December 31, 1993 respectively, and in 1995
those unpaid amounts were part of the transaction described in
paragraph 10. If those amounts are deductible in 1992 and 1993,
then the non-capital losses for those years available for carry
forward and deduction in 1996 were $305,846.86 and $325,555.82
respectively.
13.
In 1996 and 1997 the Appellant's portion of the Interest
Expense exceeded the Balance of Net Cash Flow by $1,404,045 and
$1,588,612 respectively. Those amounts were due and payable on
December 31, 1996, and December 31, 1997 respectively, and in
1998 the Appellant entered into a similar transaction to that
described in paragraph 11, with the amount of the purported
payment being $2,714,095.
14.
By further amendments of January 1, 1999, the parties agreed to
reduce the stated interest rate from 10% per annum to 4-1/4% per
annum, and by altering the cash flow percentage such that 95% of
cash flow goes to Postel, 5% to the Co-owners.
15.
Over the period 1974 the Appellant received the following cash
payments pursuant to the Lease as amended:
|
1975
|
3,799
|
|
1976
|
92,657
|
|
1977
|
130,330
|
|
1978
|
185,704
|
|
1979
|
201,665
|
|
1980
|
226,284
|
|
1981
|
239,870
|
|
1982
|
307,870
|
|
1983
|
352,268
|
|
1984
|
300,701
|
|
1985
|
247,780
|
|
1986
|
476,671
|
|
1987
|
371,693
|
|
1988
|
318,920
|
|
1989
|
268,871
|
|
1990
|
247,219
|
|
1991
|
243,496
|
|
1992
|
21,259
|
|
1993
|
51,903
|
|
1994
|
187,633
|
|
1995
|
247,979
|
|
1996
|
175,451
|
|
1997
|
230,384
|
|
1998
|
169,400
|
|
1999
|
222,337
|
|
2000
|
165,376
|
|
2001
|
62,466
|
|
|
5,749,986
|
These amounts were included in computing his income, but
because of the Interest Expense the Appellant has to date
reported no net profits for tax purposes.
16.
The Appellant was first assessed for his 1995 taxation year on
May 16, 1996, which year was statute barred by the date of the
issuance of the reassessments now appealed from, which
reassessments were issued on May 19, 2000 for 1996 and July 17,
2000 for 1997.
[3]
In addition to the Partial Agreed Statement of Facts, I heard the
testimony of Mr. Clayton Bzdel, an officer of Harvard
Developments Ltd. ("HDL"). He clarified the discrepancy
in paragraph 13 of the Agreed Statement of Facts between the
excess interest expense of $2,992,657 in 1996 and 1997 and the
amount of $2,714,095 paid in 1998. The difference arose due to a
partial prepayment in 1995 and an accounting miscalculation which
was rectified by a payment in 2000. Mr. Bzdel also explained that
the reason for the reduction in the interest rate in 1995 and
1999, with an increase in the cash flow to Postel was to
"try to get this mortgage in a form that would allow it to
be paid out within the term". He acknowledged that the 4.25
percent interest rate was not the market rate, but was a rate
negotiated in 1998 that would allow the mortgage to be paid out
within the term.
[4]
As well as the segments of documents reproduced in the Partial
Agreed Statement of Facts, I wish to highlight the following
excerpts from certain of the documents:
(a)
Paragraph 7 and 8 of the December 22, 1983 mortgage:
SEVENTHLY: That if the Mortgagor shall make
default in payment of the moneys hereby secured or any part
thereof or any interest thereon at any of the hereinbefore
appointed times and such default continuing for one (1) month
after notice thereof is given by the Mortgagee to the Mortgagor,
then the Mortgagee shall have the right and power and the
Mortgagor doth hereby covenant with the Mortgagee for the said
purpose and doth grant to the Mortgagee full license and
authority for such purpose, when and so often as in its
discretion the Mortgagee shall see fit, to enter into possession
by its agent or otherwise, of the said lands, and receive and
take the rents, issues and profits thereof, and whether in or out
of possession thereof to make any demise or lease of the said
lands or any part thereof for such terms, period, and at such
rent as it shall think proper.
EIGHTLY: That in case default is made in payment of any of the
sums hereby secured and such default continuing for one (1) month
after notice thereof is given by the Mortgagee to the Mortgagor,
the Mortgagee may sell and convey the said lands, without
entering into possession of the same, and without giving any
notice to the Mortgagor, and either before or after and subject
to any demise or lease made by the Mortgagee as hereinbefore
provided, PROVIDED that any sale made under the powers hereby
given may be on such terms as to credit and otherwise as shall
appear to the Mortgagee most advantageous, and for such price as
can be reasonably obtained therefor, and that sales may be made
from time to time to satisfy any interest or any part of the
principal overdue, leaving the principal or balance thereof to
run at interest payable as aforesaid, and the Mortgagee may make
any stipulation as to title or otherwise as to the Mortgagee may
seem proper, and the Mortgagee may buy in or rescind or vary any
contract for sale of any of the said lands, and resell without
being responsible for any loss occasioned thereby, and for any of
the said purposes may make and execute such agreements and
assurances as shall be by the Mortgagee deemed necessary.
and paragraph 23 and 24 of the December 22, 1983 mortgage:
TWENTY-THIRDLY: Notwithstanding anything
contained herein, it is expressly agreed by and between the
Mortgagor and the Mortgagee that the Mortgagee's rights to
recover principal and interest owing under this Mortgage shall be
restricted to the lands including, without restricting the
generality thereof, those items described in paragraph Eighteen
of this mortgage.
TWENTY-FOURTHLY: In the event of a bona fide
offer from a third party to purchase
(a)
all Mortgagor's rights and interest as Lessee in the Lease
and in the building and land herein mortgaged, together with
(b)
the Mortgagee's interest in this Mortgage and its
reversionary interest in the mortgaged land,
Mortgagee shall be entitled to require payment of a prepayment
entitlement equal to sixty (60) months' interest on the
then outstanding balance of principal under this Mortgage at the
prevailing interest rate set forth in Schedule "A"
hereunder in recognition of the long term, unique nature of the
commitment and the credit granted by Mortgagee with respect to
the Lease and this Mortgage and of the substantial investment by
Mortgagee therein, but in no event will the operation of the
above obligate the Mortgagor to pay Mortgagee in excess of eighty
per cent (80%) of the proceeds of the sale or transfer.
(b) A
memo from Bill Berezan (Chief Financial Officer of HDL) of
December 22, 1995:
1.
On Wednesday, the CIBC-Regina will obtain the exchange rate for
conversion of Canadian dollars into Pounds Sterling and purchase
the equivalent of $60,370,000 Canadian in Pounds Sterling
(hereinafter referred to as " £ Amount").
2.
CIBC-Regina will wire transfer to Barclays Bank - London
("Barclays") the £ Amount. Barclays is
CIBC's correspondent bank as the CIBC does not have a
retail bank in London, England. Accordingly, the wire transfer
will take two business days to settle, and therefore the money
will probably not be in Barclays for CIBC - London's
purchases until Friday, December 29, 1995.
3.
Upon the CIBC - Regina obtaining the £ Amount (Step
1), they will advise Harvard Developments Limited
("Harvard") who in turn will advise Postel of the
£ Amount which will be required. Postel will make
arrangements with the Royal Bank of Scotland ("RBS")
such that Postel will deposit with the RBS the £ Amount on
Friday, December 19, 1995. RBS will have a bank draft in the
£ Amount prepared.
4.
Barclays shall deliver to the CIBC - London a bank draft
(Step 2) in the £ amount first thing Friday morning, and
the CIBC will walk this bank draft over to RBS.
5.
RBS and CIBC - London shall exchange the bank drafts which
they each hold on behalf of their clients, Postel and Harvard
respectively. The bank draft CIBC-London will be presenting on
behalf of Harvard shall represent the accrued interest Harvard
owes to Postel. The bank draft which RBS will be presenting on
behalf of Postel represents the advancing of principal funds by
Postel to Harvard.
6.
RBS will then deposit the Barclays bank draft to the Postel
account.
7.
CIBC - London will return to Barclays to deposit the RBS bank
draft and in turn, Barclays will wire transfer this money to CIBC
- Regina.
(c)
Paragraphs 1 to 3 of the Memorandum of December 27, 1995 from
Bill Berezan:
1.
Today, Wednesday, December 27, 1995, CIBC - Regina has
wired for delivery on Friday £ 28,476,415.09 to Barclays
Bank - London ("Barclays") for the account of
CIBC - London. The exchange rate utilized was $2.12 Cdn. =
£ 1.
2.
Tomorrow, Thursday, December 28, 1995, CIBC - London will
present to the Royal Bank of Scotland ("RBS") an
agreement relating to the electronic exchange of funds. This
agreement will basically state that RBS will not credit to Postel
Properties Ltd. ("Postel") bank account the funds
transferred from the CIBC
3.
On Friday, December 19, 1995, Barclays Bank - London shall
wire transfer to RBS £ 28,476,415.09 to RBS to the credit of
Postel bank account (subject to the agreement mentioned in number
2 above). These funds represent the accrued interest due Postel
by Harvard Developments Limited ("Harvard"). At the
same time, RBS will wire transfer to CIBC - Regina to the
bank account of Harvard £ 28,476,415.09. These funds
represent the further advancement of principal funds by Postel to
Harvard.
(d)
Letter of December 28, 1995 from CIBC:
December 28, 1995
The Royal Bank of Scotland, PLC
4th Floor, Waterhouse Square,
138/142 Holborn
London EC1N 2TH
Attention : Ms F James
RE : Norcen
Building, Calgary, Alberta
Postel Properties Ltd. Mortgage
We are advised by our customer, Harvard Developments Ltd. that
they owe £ 28,476,415.09 to Postel Properties Ltd in respect
of accrued interest outstanding under a mortgage advance. We are
also advised that on condition that the interest payment is made,
Postel Properties Ltd have agreed to advance a further capital
sum of £ 28,476,415.09 under the existing mortgage and that
both payments are to be made simultaneously.
We have been asked to make the interest payment on behalf of
Harvard Developments Ltd and we are informed that you will be
instructed to make the corresponding payment on behalf of Postel
Properties Ltd.
For value December 29, 1995 we are therefore paying to you
£ 28,476,415.09. These funds are to be held in Trust for our
account and may only be released to Postel Properties Ltd
simultaneously with you actioning transfer of
£ 28,476,415.09 to Barclays Bank, St Swithins House, St
Swithins Lane London, sort code 20-32-53 for account of CICB
London A/C no 00121347 re Harvard Developments Ltd.
We record your agreement to refund the funds to us in full by
3 pm on December 29, 1995 if you have not actioned an instruction
from Postel Properties Ltd. as outlined above.
Please confirm agreement to the above terms on the attached
duplicate of this letter.
Yours faithfully
« signature »
A.D. Craig
General Manager,
Credit Risk Management.
Agreed 28th December 1995
For and on behalf of :
The Royal Bank of Scotland PLC
[5] I
find the following to be the chronology of events in December,
1995:
1.
December 27, 1995 Appellant received approval to borrow
28,476,415 Pounds from CIBC (Regina), which is deposited to the
Appellant's account in Regina.
2.
December 27, 1995 CIBC (Regina) wired 28,476,415 Pounds to
Barclay's Bank (London) for the account of CIBC (London).
3.
December 28, 1995 CIBC (London) presented an agreement to the
Royal Bank of Scotland which stated that the Royal Bank of
Scotland will not credit Postel's bank account with the funds
transferred from CIBC (London) until the Royal Bank of Scotland
has wire transferred to CIBC (Regina) the identical amount of
funds.
4.
December 29, 1995 Barclay's Bank wire transferred 28,476,415
Pounds to Royal Bank of Scotland to the credit of Postel's
bank account.
5.
Coincidentally, Royal Bank of Scotland wire transferred to CIBC
(Regina) to the bank account of HDL 28,476,415 Pounds.
ISSUES:
[6]
The parties agreed prior to trial that the issues were:
1.
Whether the differences between the balance of net cash flow and
the interest expense in the years 1992 and 1993, and 1996 and
1997 were amounts payable in those years or were contingent
liabilities.
2.
Whether the differences between the balance of net cash flow and
the interest expense in 1996 and 1997 were compound interest,
deductible only when paid. This will occur:
(a)
if the purported payment of interest and borrowing of a like
amount of principal can be ignored at law; or
(b)
if the general anti-avoidance rules apply to permit the Minister
to ignore the purported payment of interest in 1995 and the
borrowing of a like amount as principal.
3.
Whether the Appellant's investment in the project had a
reasonable expectation of profit.
[7]
While there was some suggestion by Mr. Gosman at trial that he
was relying on the compound interest argument with respect to the
1992 and 1993 years, he did not pursue this avenue in his written
argument.
ISSUE: Were the excess interest amounts in 1992, 1993,
1996 and 1997 amounts payable in those years or contingent
liabilities?
APPELLANT'S SUBMISSIONS:
[8]
The Appellant submitted that the answer lies within the documents
themselves and particularly the wording of paragraph 2 of
Schedule A of the Mortgage. This, the Appellant claimed, is not
impacted by paragraph 3 which is subordinate to paragraph 2 and
is simply a mechanism for interest to be charged on the unpaid
excess amount if such excess is not paid on December 31 of each
year. Paragraph 3 does not deprive the mortgagee of the right to
demand payment of the excess interest. The Agreement is clear
that the excess interest is payable. The Appellant also argued
that the Respondent had admitted both in the Reply and in the
Agreed Statement of Facts that the excess amounts were
payable.
[9]
In connection with the contention that the interest payment was
contingent, the Appellant relied on Justice Sharlow's
comments in Wawang Forest Products Ltd. v. Canada [2001]
F.C.J. No. 449:
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.
The Appellant argued that there was an enforceable legal
obligation on December 31 in each year, which obligation was not
dependent upon any future event. The recourse of the mortgagee to
a percentage of sale proceeds in the event of a third party sale
is a credit risk, not a contingency denying the mortgagee of his
right to demand payment annually. In any event, by the payments
made in 1995 and 1998 the enforceable liability for the
outstanding interest was paid.
[10] The
Appellant refuted the applicability of the Barbican Properties
Inc. v. The Queen, 97 DTC 122, affirmed 97 DTC 5008 (F.C.A.),
Global Communications Limited v. The Queen, 99 DTC 5377
(F.C.A.) and Redclay Holdings v. R., 96 DTC 1207 on the
basis that in each of those cases there was no enforceable legal
obligation to pay the interest in the year in which the deduction
was sought.
RESPONDENT'S SUBMISSIONS:
[11] The
Respondent argued that the Appellant was not under a legal
obligation to pay the excess interest on December 31. In support
of this argument the Respondent referred to paragraph 3 of
Schedule A of the mortgage. This paragraph stipulates that unpaid
excess interest is to be added to the principal owing. The
Respondent cited the conduct of the parties as evidence that they
did not intend to enter into a legally binding obligation to pay
the excess interest, mentioning specifically the comments of the
Chief Financial Officer of HDL in a letter of December 17, 1996
which read in part as follows:
There is nothing in this wording that suggests the excess must
be actually paid on December 31, but only that it shall accrue
and become payable, presumably meaning it can actually be paid on
any subsequent date.
[12] The
Respondent cited other examples of conduct confirming that there
was no intention that the excess interest be paid: firstly, the
fact that Postel never demanded payment and secondly, that the
$35,000,000 cap on principal was removed. This confirmed that the
parties' intent was that the excess interest would be
automatically added to principal.
[13] With
respect to the contingent liability argument, the Respondent
submitted that as the mortgagee's recourse on the debt was
limited to the value of the property, or 80 percent of the
proceeds if sold, the Appellant's liability for excess
interest was a contingent liability. The Respondent highlighted
that as of the end of 1998 the principal had accumulated to over
$110,000,000, while the value of the property was only $42 to
$44,000,000, suggesting that there was no reasonable certainty
that the interest would ever have been paid.
[14] In
support of the notion that the Appellant's liability is a
contingent liability the Respondent cited a number of cases
(Barbican, Global Communications, supra and
McLarty v. Canada, 2001 T.C.J. No. 59). The Respondent
attempted to distinguish the decision in Wawang on the
basis that in Wawang the Court was dealing with payments
under a construction contract being held back, and further, that
there was no doubt the amounts held back were legally required to
be paid.
ISSUE: Did the transactions in December, 1995 constitute
the payment of interest and the borrowing of a like amount as
principal, resulting in the excess interest in 1996 and 1997
being simple interest as opposed to compound
interest?
APPELLANT'S SUBMISSIONS:
[15] The
Appellant's position was that the Court simply could not
ignore the payment by the Appellant of outstanding interest in
1995 and the borrowing of a like amount of principal at the same
time. As the Respondent conceded that the 1995 transaction was
not a sham, it was the Appellant's position that there was
no legal basis for the Court to ignore the legal relationships
created by the written agreements and executed by the parties in
December, 1995. The Appellant relied on the case of MacNiven
v. Westmoreland Investment Ltd., 2001 H.L.J. No. 6 to support
its assertion. In Westmoreland, the company owned by a
pension plan was loaned money by the plan to repay its debt to
the plan. The Court found that although the taxpayers in that
case were passing money around in a circle, it did constitute a
legal payment. As indicated by Lord Nicholls:
Leaving aside sham transactions, a debt may be discharged and
replaced with another even when the only persons involved are the
debtor and creditor.
[16] Finally,
the Appellant indicated that it was not open for the Court to
adopt an economic reality approach, citing the rejection of such
an approach by the Supreme Court of Canada in John R.
Singleton v. The Queen, 2001 S.C.C. 61 where Justice Major
said:
In examining the Minister's argument about the need to
consider the economic realities of a transaction rather than
being bound to its strict legal effects, McLachlin, J. recognized
(in Shell Canada v. The Queen) that the Courts must be
sensitive to the economic realities of a transaction. However,
she stated that (paragraphs 39 to 40):
This Court has never held that the economic realities of a
situation can be used to recharacterize a taxpayer's
bona fide relationship. To the contrary, we have held
that, absent a specific provision of the Act to the contrary or a
finding that they are a sham, a taxpayer's legal
relationships must be respected in tax cases.
RESPONDENT'S SUBMISSIONS:
[17] The
Respondent argued that the purported "payment" in
1995 was a not a legally valid payment and as such the interest
on the interest was not "converted" to principal but
remained compound interest.
[18] It was
the Respondent's position that no valid payment occurs
where the amounts are conditionally and simultaneously exchanged
between parties in a single transaction. In support of this
argument, the Respondent submitted that in M.N.R. v. Cox,
71 DTC 5150 (S.C.C.) the Court found that the simultaneous
exchange of cheques was a single transaction and not a payment.
The Respondent indicated the Cox decision was cited in
Western Union Insurance Co. v. R., 83 DTC 5388 (F.C.T.D.)
where the Court found that a cheque given over and immediately
returned did not constitute payment.
[19] The
Respondent stated that the transaction purporting to effect the
payment of interest and a re-loaning of the funds was a single,
simultaneous transaction, whereby each transfer was conditional
upon the identical amount of funds being transferred to the
other. The Respondent quoted Black's Law Dictionary
definition of payment as follows:
The fulfilment of a promise, or the performance of an
agreement. A discharge of an obligation or debt, and part
payment, if accepted, is a discharge pro tanto. In a more
restricted legal sense payment is the very performance of a duty,
promise or obligation or discharge of a debt, or liability, by
the delivery of money or other value by a debtor to a creditor,
where the money or other valuable things tendered and accepted as
extinguishing debt or obligation in whole or in part.
[20] The
Respondent argued that a valid payment required the extinguishing
of the debt. In the present circumstances the Respondent
submitted that as the transactions were simultaneous and
conditional upon re-loaning of funds, at no point was the debt
extinguished.
[21] The
Respondent's position was not that the 1995 transaction was
a sham or that any particular aspect should be ignored, rather
that such a conditional exchange simply does not legally affect
payment.
[22] As the
Respondent claimed that there was no legal payment of the excess
interest in 1995, the amounts sought to be deducted by the
Appellant are properly characterized as compound interest.
Pursuant to paragraph 20(1)(d) compound interest can only
be deducted when actually paid in the year. As the amounts were
not paid in the years in which they are being claimed they are
not deductible.
ISSUE: Did the Appellant's investment have a
reasonable expectation of profit?
APPELLANT'S SUBMISSION:
[23] The
Appellant argued that the Respondent did not raise this issue in
issuing the reassessment. Relying on the case of Coleman v.
R., (1999) 1 C.T.C. 38 the Appellant maintained that because
the assertion was not a basis of reassessment and was only first
raised in the pleadings, the onus rests on the Respondent to
prove that the expectation of profit was "irrational,
absurd, or ridiculous". Relying on the recent case of
Ludco Enterprises v. The Queen, 2001 S.C.R. 62, the
Appellant rejected the notion of profit or net income as being
the appropriate test, but rather the test was an expectation of
income. In this case, the Appellant maintained, there can be no
doubt that there was a reasonable expectation of substantial
income. In fact, the Appellant received a cash return of
approximately $5,750,000.
RESPONDENT'S SUBMISSION:
[24] The
Respondent submitted that not only was there never any profit
during the life of the project but that in fact the losses were
intentional.
[25] The
Respondent rejected the notion that the Coleman case stood
for the proposition that the appropriate test is whether the
expectation of profit was "irrational, absurd, or
ridiculous". However, the Respondent went on to indicate
that even following such a proposition the expectation of profit
in this case was indeed irrational, absurd or ridiculous.
ISSUE: Do the general anti-avoidance rules
("GAAR") apply to permit the Minister to ignore the
purported payment of interest in 1995 and the borrowing of a like
amount as principal?
APPELLANT'S SUBMISSIONS:
[26] The
Appellant did not deny that the arrangement was entered into to
ensure that interest payable on the indebtedness was simple
interest and not compound interest. However, the Appellant
maintained that subsection 245(4) requires that there has been a
misuse of the provisions of the Act or an abuse having
regard to the provisions of the Act read as a whole and in
this instance neither has been proven.
[27] The
Appellant relied on Justice Rothstein's approach in OSFC
Holdings Ltd. v. The Queen, and in particular his view that
the Respondent must demonstrate a relevant, clear and unambiguous
policy. The Appellant maintained that there is no policy, let
alone a clear and unambiguous policy that would prevent a
taxpayer from borrowing to meet an obligation to pay interest,
even if the purpose is to avoid the subsequent incidence of
compound interest on that interest. As Justice Rothstein
indicated:
There is no onus to be satisfied by either party at this stage
of the analysis. However, from a practical perspective, the
Minister should do more than simply recite the words of
subsection 245(4) and allege there has been a misuse or abuse.
The Minister should set out the policy with reference to the Act
or its intrinsic aids upon which he relies.
RESPONDENT'S SUBMISSIONS:
[28]
Similarly, the Respondent acknowledged that the argument in
connection with GAAR can be limited to a "misuse and
abuse" analysis. The Respondent indicated that the violence
done to the Act in this situation was the avoidance of the
application of paragraph 20(1)(d) of the Act utililizing a
legal form to convert non-deductible unpaid compound interest
into deductible simple interest. With respect to the requirement,
as outlined in Justice Rothstein's comments in OSFC
Holdings Ltd. that there be a clear and unambiguous policy, the
Respondent repeated the provisions of the Act allowing the
deduction of simple interest on an accrual basis and denying the
deduction of compound interest on an accrual basis.
[29] The
Respondent also suggested that the policy of the Income Tax
Act and its treatment of interest can be gleaned from a
consideration of section 80, the debt forgiveness rule. Paragraph
80(2)(b) applies to forgiven interest amounts for which
deductions have been taken but payments have not been made. Since
compound interest is not deductible unless paid, this provision
does not apply to forgiven yet unpaid compound interest. The
Respondent reiterated that this is illustrative of the policy of
the Act being that compound interest must be paid in order to be
deductible.
ANALYSIS:
ISSUE: Were the excess interest amounts in
1992 and 1993, and 1996 and 1997 amounts payable in those years
or contingent liabilities?
[30] The
starting point is the Mortgage Agreement itself and it is
worthwhile to repeat the first part of section 2 and section 3 of
Schedule A of that Agreement:
2.
The Mortgagor shall pay to the Mortgagee the Interest Payment on
each Payment Date during the Term, Provided However, if the
Interest Expense on any Payment Date exceeds the Balance of Net
Cash Flow Payable to the Mortgagee, then the amount of said
excess shall accrue due and be payable to the Mortgagee on the
31st day of December in each year. Up to and including
the year 1994, upon payment by the Mortgagor of any excess as
aforesaid, Mortgagor may request in writing from the Mortgagee an
advance of such excess. Mortgagee shall, within thirty (30) days
of such request, advance to the Mortgagor the amount of such
excess requested by Mortgagor, provided that the Principal of the
Mortgage shall never exceed Thirty Five Million Dollars
($35,000,000).
3.
Subject to paragraph 2 above, if the mortgagor does not pay the
mortgagee the excess of the interest expense on any payment date
over the balance of the net cash flow, such excess shall be added
to the balance of the principal and shall bear interest at the
rate stipulated in this schedule at the relevant period.
What is missing from this wording, which is fatal to the
Respondent's submissions, is any suggestion that the
Appellant's rights have been restricted such that section 3
is the Appellant's only relief in the event of non-payment.
The provision just does not go that far. The agreement does not
expressly state, nor can it even be implied, that the Appellant
has agreed to give up its right to sue for the excess interest. I
find that the use of the term "shall accrue due and be
payable to the mortgagee on the 31st day of December
in each year" (found in paragraph 2 of Schedule A) is not
so fundamentally different from "shall pay" as
suggested by the Respondent. On December 31 of each year the
mortgagee could sue for its excess interest based on the wording
of sections 2 and 3.
[31] I also do
not find that the contractual right of the Appellant to request
the excess interest from Postel with a corresponding obligation
from Postel to lend such funds to the Appellant negates
Postel's right to seek payment every December 31. The
consequence flowing to Postel if it insisted upon payment of the
excess interest was that it might have to lend the Appellant the
money to make the payment. The Agreement does not state that the
Appellant can only pay with funds borrowed from Postel but just
that the Appellant may request such funds.
[32] I do not
accept the Respondent's suggestion that the parties'
behaviour leads to the conclusion that they never intended to do
anything other than add the excess interest to the principal, and
that there was therefore no legal obligation to pay on December
31 of each year. The Respondent cannot simply impose a form of
promissory estoppel on the parties. Whatever the parties'
business conduct might lead a third party to surmise, I find the
parties remained bound to an agreement that in clear terms gave
the mortgagee the right to seek the excess interest every
December 31. Nothing in the agreement itself deprives the
mortgagee of this right. Further, I have not been made aware of
any principle, other than promissory estoppel, (which is not here
raised by a party to the contract) which stipulates that the
subsequent conduct of the parties displaces the clear wording of
the agreement.
[33] Having
found there was a liability to pay the excess interest, I must
now determine if that liability was contingent due to the limited
recourse nature of the indebtedness. I wish first to comment on
the applicability of paragraph 24 to the situation facing the
Appellant in 1996 and 1997, as I do not see it as relevant to the
Respondent's contingency liability argument. The provision
requires a two pronged offer. One to the mortgagor for its
leasehold interest, and the other to the mortgagee for its
interest under the mortgage. This offer would make perfect sense
in a situation where the mortgage is not in arrears and the
purchaser wishes to acquire the property outright, unencumbered.
The purchaser would make a payment to each of the parties with an
interest in the property. The mortgagor (the Appellant) would
then be obliged to pay part of its payment (five years'
prepayment of interest) over to the mortgagee, subject to the
eighty percent of proceeds restriction. There is no
"contingency" regarding the interest in this
situation.
[34] However,
consider also the actual circumstances in 1996 and 1997 when the
principal and interest far exceeded the value of the property: no
third party purchaser would ever make any offer to the Appellant
as the Appellant's interest was worthless. The only
reasonable offer would be to the mortgagee to take over its
interest under the mortgage and its reversionary interests, and
then be in a position to simply foreclose on the mortgagor. If
Postel was prepared to sell its interest in the mortgage to a
third party for something less than the amount owed by the
mortgagor, that does not relieve the mortgagor of its liability
for interest. It simply replaces Postel as mortgagee. The only
situation where the mortgagor is relieved of any interest
obligation is pursuant to paragraph 7 and 8 and paragraph 23 of
the mortgage, where the mortgagee may take possession of the
land, or sell the land, but cannot seek any deficiency. This can
be the only "contingency" at issue.
[35] Assuming
then that the mortgagee demanded payment, presumably the
Appellant could have responded by simply surrendering the lease
and handing back the property. In December 1995, according to a
letter of December 21, 1995 from HDL to Postel's lawyers,
the total indebtedness was principal of approximately $30,000,000
and interest of approximately $60,000,000. The value of the
property in 1996 and 1997 was estimated to be in the range of
$42,000,000 to $44,000,000. So, had the property been simply
delivered back to Postel, Postel would have been limited to
receiving value equivalent to all of the principal plus some
interest. The Respondent suggested that this situation
highlighted that there was no reasonable certainty that the
outstanding interest would ever be paid. But is this a contingent
liability as contemplated by paragraph 18(1)(e) which
would deny the Appellant the interest deduction? It is not.
[36] Justice
Sharlow in the Wawang case reiterated the test for the
determination of a contingent liability as set out in Winter
and Others (Executors of Sir Arthur Munro Sutherland (deceased))
v. Inland Revenue Commissioners, [1963] A.C. 235 (H.L.), as
follows:
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.
Justice Sharlow went on to say:
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.
Finally, Justice Sharlow further addressed the risk of
collection of a debt as follows:
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.
[37] The
existence of the Appellant's liability to pay the mortgagee
the excess interest was not contingent on any future event. If
the property values did not increase significantly, the mortgagee
had contractually bound itself to accepting less than the
outstanding indebtedness by simply taking the property back,
however, there always existed a liability which did not depend on
the vagaries of the Alberta real property market for its very
existence.
[38] The
Respondent relies on the earlier decisions of Barbican and
Global for support that a limited recourse loan does
indeed constitute a contingent liability. I do not read those
cases as going that far. In the Barbican case the Tax
Court Judge found there was no legal obligation to pay unless and
until one of two conditions were met; the conditions were that
net cash flow exceeded the interest payable or that there was a
sufficient capital appreciation of the properties at the time of
sale. I can find no wording in the documents in this case to
suggest there is no legal obligation to pay interest until the
value of the property increased to greater than the outstanding
indebtedness. The relevant provisions are not framed in such
terms.
[39] In the
Global Communications case what was at issue was a limited
recourse promissory note, described by Justice Robertson as
follows:
Under the promissory note given by Global to Technical,
interest accrued at the rate of five percent per annum and was
not payable until the note matured on August 29, 1998 or the
extension date August 29, 2001. Recourse under the note was
limited to that which could be realized on the sale of the Global
data and any Canadian oil and gas leases that Global held at the
time the note came due. In short, Global could not be sued for
any deficiency under the note.
[40] In his
analysis, Justice Robertson goes on to say:
In the present case, the limited recourse promissory note
represents a contingent liability, since it only arises to the
extent that licensing revenue is generated which, by definition,
is an uncertain event. There is no question that there is an
underlying debt in respect to Global's purchase of the
seismic data. It is equally true that personal liability will
attach to Global with respect to licensing revenues actually
received. Until such revenues are received however,
Global's liability to pay the proceeds and ultimately the
balance of the purchase price is a contingent one.
Understandably, tax law does not permit the deduction of an
expense which may not have to be paid.
[41] That does
not accurately describe the situation before me. Postel at any
time could have demanded payment of the excess interest. The
Appellant, if in a position to do so, could have paid it, could
have borrowed from Postel to pay it, or could have surrendered
its leasehold interest back to Postel. Had the Appellant taken
the latter route and transferred property worth an amount that
covered all of the principal and some of the interest, would the
result have been a windfall to the Appellant; that is, would the
Appellant have obtained a deduction of an interest expense which
was ultimately not paid? No, as the debt forgiveness rules in
section 80 would operate to adjust the tax impact of the
previously deducted interest.
[42] To deny
interest deductibility on the basis that a limited recourse
mortgage creates a contingent liability, creates the possibility
of every such mortgagor being denied any interest deductibility.
For example, what is the result if interest is accrued, its
deductibility is denied, and the property is subsequently sold
with most of the accrued interest being paid from the sale
proceeds? Does the interest paid in the year of sale qualify for
a deduction pursuant to paragraph 20(1)(c)? In this
scenario to qualify under paragraph 20(1)(c) requires that
the cash method was the method regularly followed by the
taxpayer. It could be argued that one payment of accrued interest
in the year of sale does not constitute the cash method. This
leads to something of an absurdity in that it denies the
deductibility of a legitimate interest expense payment. This
suggests to me a potential pitfall in finding a limited recourse
loan transforms the interest liability into a contingent
liability only.
[43] A further
reason for remaining unconvinced the liability arising every
December 31 is contingent relates to the timing of that
determination. To determine the contingency nature of the
liability at any point in time could require an assessment of the
fair market value of the property at that point with a comparison
to the outstanding indebtedness. If the value of the property
surpasses the outstanding indebtedness in a limited recourse
mortgage, how can it be found that there is any contingency;
whereas, conversely, if the fair market value is significantly
less than the outstanding indebtedness, such as the case at hand,
it may be that the annual interest payable amount may or may not
ever be collected by the mortgagee. The commercial prospect of
frequent real estate appraisals to determine how contingent is
the liability and consequently whether interest is deductible,
would send shivers down the backbone of the Canadian real estate
industry. It also leads me to the conclusion that the
determination of whether the interest liability arising from a
limited recourse mortgage is contingent should not be a frequent
determination, but should be gleaned from the wording of the
mortgage and the circumstances existing at the time the mortgage
was entered into. Presumably at that time the debt is less than
the value of the property. The interest liability should not
subsequently be considered contingent due to the possibility of a
declining real estate market or skyrocketing interest rates.
[44] There is
no evidence at the time this provision was agreed to that there
were any exceptional circumstances to suggest it was some
interest deductibility scam. It is a limited recourse mortgage;
if there was a default, the mortgagee could get back the property
and make a decision whether or not to sell the property. I find
the interest liability was not one which depended for its
existence on the mortgagee's right to foreclose; it is not
a contingent liability.
ISSUE: Did the transactions in December, 1995 constitute
the payment of interest and the borrowing of a like amount as
principal, resulting in the excess interest in 1996 and 1997
being simple interest as opposed to compound
interest?
[45] This
issue hinges entirely on the true legal nature of the
transactions in December, 1995. If what transpired at that time
was indeed the payment of the accrued excess interest, then the
interest owing in 1996 and 1997 was not interest on that accrued
interest, but was simple interest and therefore deductible. If
the December, 1995 transaction does not constitute payment of the
accrued interest, then the 1996 and 1997 interest liability is
compound interest, only deductible when paid.
[46] The
starting point for the analysis is the following wording of the
mortgage agreement:
Upon the payment by the mortgagor of any such excess as
aforesaid the mortgagor may request in writing from the mortgagee
an advance of such excess and the mortgagee shall forthwith
following such request advance to the mortgagor the amount of
such excess and any amount so advanced shall be added to and
included in the principal.
[47] So,
clearly Postel obliged itself to lend to the Appellant, on
request, an amount equal to any amount of excess interest paid by
the Appellant to Postel. The document contemplates a payment of
funds from the Appellant to Postel followed by an additional
loan.
[48] The
Appellant intended to, and indeed did take great pains to
structure the December, 1995 transaction as the payment of one
debt and the borrowing of a new debt. The purpose was to ensure
the deductibility of interest, by getting around the compound
interest obstacle.[1] I am satisfied that both the Appellant and Postel made
arrangements to have the requisite funds (approximately
$60,000,000 Cdn or 28.8 million Pounds) available for what the
parties refer to as the "cheque exchange". The
Appellant arranged for its funds by way of loan from the CIBC.
There is no evidence of where Postel came up with its
$60,000,000, but clearly it did.
[49] The
Respondent argues that as the steps in this "cheque
exchange" were conditional on one another, no debt was ever
extinguished, and a debt must be extinguished to constitute
payment. I have difficulty in identifying any moment in time when
the Appellant did not owe Postel exactly $60,000,000; the
Appellant never for an instant owed $120,000,000 to Postel, nor
did the Appellant ever for an instant owe Postel nothing. There
was a continual outstanding indebtedness of $60,000,000. At the
exact same moment in time that the Appellant released $60,000,000
to Postel, Postel released $60,000,000 to the Appellant. The
Supreme Court of Canada indicated in the Cox case :
The simultaneous exchange of cheques, where neither
would be honoured due to insufficient funds were it not for the
offsetting entry of the other cheque, can only be viewed
as a single transaction.
(emphasis added)
[50] However,
the cheque exchange before me is distinguishable as both the
Appellant and Postel had arranged for sufficient funds such that
the cheques (wire transfers) would indeed be honoured, and in
fact were honoured. There were readily identifiable funds of
$60,000,000 from each side of the transaction: it was not a
matter of each side relying on the other side's funds for
their cheques to be honoured. If the conditions were met, that
is, if you have your money ready and I have mine ready, the
exchange is completed. This is quite different from parties
recognizing that neither side really needs to have any money
ready for an exchange.
[51] I agree
with the Respondent that "payment" means discharge of
an obligation or a debt, and that in this case there was a
continuous obligation of the $60,000,000, yet something did
intervene to change the nature of that indebtedness. What
intervened was the creation of certain legal relationships. The
Supreme Court of Canada addressed the role of legal relationships
vis-à-vis the economic realities of a situation in the
recent Singleton case in the following manner:
In examining the Minister's argument about the needs to
consider the economic realities of a transaction rather than
being bound to its strict legal effect, McLachlin, J. recognized
(in Shell Canada v. The Queen) that the Courts must be
sensitive to the economic realities of a transaction. However,
she stated that (paragraphs 39-40):
This Court has never held that the economic realities of a
situation can be used to recharacterize the taxpayer's
bona fide relationships. To the contrary we have held that
absent a specific provision of the act to the contrary or the
finding that they are a sham, the taxpayer's relationship
must be respected in tax cases.
and at paragraph 32:
The Tax Court Judge found that the purpose in using the money
was to purchase a house and that this purpose could not be
altered by the "shuffle of cheques" that occurred on
October 27, 1988. I respectfully disagree. It is this
"shuffle of cheques" that defines the legal
relationship which must be given effect.
[52] I find I
am faced with a similar dilemma. I feel much as Lord
Nicholl's must have felt when he indicated in the House of
Lords case of MacNiven v. Westmoreland Investments Ltd.,
2001 U.K.H.L. 6 :
My Lords, I confess that during the course of this appeal I
have followed the same road to Damascus as Peter Gibson L.J. Like
him, my initial view, which remained unchanged for some time, was
that a payment comprising a circular flow of cash between
borrower and lender, made for no commercial purpose other than
gaining a tax advantage, would not constitute payment within the
meaning of 2. 338. Eventually, I have found myself compelled to
reach the contrary conclusion.
...
I must elaborate a little. In the ordinary case the source
from which a debtor obtains the money he uses in paying his debt
is immaterial for the purpose of s. 338. It matters not whether
the debtor used cash-in-hand, sold assets to raise the money, or
borrowed money for the purpose. Does it make a difference when a
payment is made with money borrowed for the purpose from the very
person to whom the arrears of interest are owed? In principle, I
think not. Leaving aside sham transactions, a debt may be
discharged and replaced with another even when the only persons
involved are the debtor and creditor.
[53] The
Respondent argues that the MacNiven is distinguishable as
the facts do not support a single transaction, as the lender in
that case did not appear to attach any conditions to the loaning
of funds. The Respondent submits that the Appellant's and
Postel's exchange was "in reality a single
transaction". I believe that the Respondent is attempting
to hang its hat on an economic reality test which is not
appropriate given the comments from Justice Major in
Singleton. I find that what transpired in December, 1995
between the Appellant and Postel constituted payment of the
accrued excess interest, and consequently the excess interest in
1996 and 1997 was not compound interest.
ISSUE: Did the Appellant's investment in the
project have a reasonable expectation of profit?
[54] I cannot
imagine a better example to illustrate the foibles of the
oft-maligned REOP test than this case. The Respondent, by the
application of the REOP test, concludes that the operation of a
multi-million dollar office building over a lengthy period of
time does not constitute a business for tax purposes. A review of
every possible indicia of a business that one could identify
would result in the resounding response that yes, this project
was a business. The time spent on the project by the co-owners,
the very duration of the building's existence, the
significant capital invested, the maintenance of books and
records, the organizational structure, the behaviour of the
co-owners as operating a business, the lack of any personal
element of the Appellant and the receipt by the Appellant of
approximately $5,750,000 from the project over a 25 year period
are just some of the factors that are conclusive that indeed a
business existed. Yet out trots Moldowan and this project
is subjected to the REOP examination, with the Respondent
concluding that it does not pass the test. I cannot conceive that
Chief Justice Dickson intended to de-business (I apologize for
the bastardization of the English language, but the term seems to
fit) a project such as this, stripping it of the status of a
"source".
[55] However,
until further guidance from the Supreme Court of Canada, I am
compelled to analyze those factors which might take a legitimate
business out from under the taxing provisions of the Income
Tax Act, due to a failure to meet the REOP test. Those
factors are the Appellant's past profit and loss, the
Appellant's motivation, the capability of the project to
earn a profit and the nature and stage of the business. Given the
advancement of the REOP argument was not a basis of reassessment,
and was first raised in the Respondent's pleadings, the
onus is on the Respondent to prove the Appellant had no
reasonable expectation of profit. The Appellant argued, relying
on the Kuhlmann case, that this required proof that the
expectation of profit was irrational, absurd or ridiculous. I
agree with Judge Bowman's analysis of the Kuhlmann
case in Cober, 2001 T.C.J. No. 311 that Kuhlmann
does not establish such a new principle.
[56] The
Respondent has not proven on a balance of probabilities that the
Appellant had no reasonable expectation of profit. The Respondent
states in his argument:
The weight of the factors showing that there was no reasonable
expectation of profit (indeed that there was even no intention of
profit) is sufficient to warrant a finding of no reasonable
expectation of profit.
Yet the only factors raised in the Respondent's argument
are the following:
1.
No profit has been reported since 1974.
2.
No substantial steps were taken to turn the project around.
In a project anticipated to exist for a century, the lack of
profit in a real estate development for the first quarter of its
existence, given the volatility of both the real property market
in Alberta and the volatility of interest rates, can not be the
sole determinative of a businessperson's expectation of
profit. The Respondent has not shown that the Appellant's
motivation was other than to earn a profit over the life of this
project. The evidence from the Appellant's discovery was
that he anticipated a pay-out of the mortgage over approximately
a 15 year period, though some later evidence from his discovery
suggested that the pay-out might have been as much as 30 years.
While the period for pay-out was significantly increased, the
evidence still supports on balance an expectation of an ultimate
pay-out of the mortgage, with an expectation of profit.
[57] With
respect to the Respondent's contention that no substantial
steps were taken to turn the project around, the Respondent gave
no examples of what those steps might have been. The Appellant by
the mid-90's did take some steps in negotiating a lower
interest rate and increasing the net cash flow that went to
Postel. This may be interpreted more as a move for the survival
of the project; but nonetheless it was a common sense business
decision which neither the Respondent nor I should second guess.
Evidence was presented at the trial in the form of a projection
of the mortgage, illustrating the pay-out of the mortgage over
the next 41 years. Granted, this was based on a negotiated 4.25
percent rate, it does still suggest to me that, contrary to the
Respondent's assertions, the Appellant has taken steps to
salvage this project and to yield a profit.
[58] The
nature and stage of the business in the mid to late 1990's
was that of an established office building struggling for
survival and an owner adjusting expectations to a longer term
return but retaining profit expectations nonetheless. I find the
Appellant had a business, and that for tax purposes that business
had a reasonable expectation of profit.
ISSUE: Do the general anti-avoidance rules apply to
permit the Minister to ignore the purported payment of interest
in 1995 and the borrowing of a like amount of
principal?
[59] I now
find myself at GAAR's doorstep in a case that enticingly
beckons me to open the door and apply the GAAR provisions in
favour of the Respondent. Yet when those provisions are applied
in the manner as set forth by Justice Rothstein in the OSFC case,
the result is by no means inevitable. Indeed while I am led to
the inexorable conclusion that the transactions are avoidance
transactions within the meaning of subsection 245(3) of the
Act, they are saved from the application of subsection
245(2) by the grace of subsection 245(4) as they are not
avoidance transactions which result in a misuse of the provisions
of the Act nor an abuse of the provisions of the
Act read as a whole. My reasons for this conclusion
follow.
[60] It is
unnecessary to go through the first several steps of the GAAR
analysis as outlined by Justice Rothstein, as the Appellant
acknowledges the arrangement constitutes avoidance transactions.
The only question to be addressed is the application of
subsection 245(4). Justice Rothstein suggested the following
approach:
I think, therefore, that to deny a tax benefit where there has
been strict compliance with the Act on the ground that the
avoidance transaction constitutes a misuse or abuse requires that
the relevant policy be clear and unambiguous.
and:
Where Parliament has not been clear and unambiguous as to its
intended policy, the Court cannot make a finding of misuse or
abuse.
and:
The Court's only role is to identify a relevant, clear
and unambiguous policy, so that it may determine whether the
avoidance transactions in question are inconsistent with the
policy, such that they constitute an abuse of the provisions of
the Act, other than GAAR, read as a whole.
and:
If, by reasons of rules and exceptions of the Act, clear and
unambiguous relevant policy could not be ascertained, I would
agree with the Appellant that the application of the statutory
provisions must prevail.
and:
There is no onus to be satisfied by either party at this stage
of the analysis. However, from a practical perspective, the
Minister should do more than simply recite the words of
subsection 245(4) and allege there has been a misuse or abuse.
The Minister should set out the policy with reference to the Act
or its intrinsic aids upon which he relies.
[61] What
policy did the Respondent identify, as clearly it is for the
Minister to set out the policy. Let me quote paragraphs 63 and 64
of the Respondent's written argument:
63.
In addition, the policy of the Act as a whole regarding the
deductibility of interest should take account the following
factors. Paragraph 20(1)(c) permits a deduction for computing
income from a business or property of interest paid or payable in
the year. A specific provision is required in respect of such a
deduction because courts have held that interest is on capital
account. Absent a statutory provision permitting the deduction,
interest would not be an income deduction, owing to the general
limitation regarding capital deductions found in paragraph
18(1)(b) of the ITA. The statutory provisions enacted by
Parliament permit the deduction of simple interest on an accrual
basis and compound interest only when paid.
64.
The policy of the ITA in its treatment of interest can also be
gleaned from a consideration of section 80, the debt forgiveness
rules. Paragraph 80(2)(b) applies to forgiven interest amounts
for which deductions have been taken but payments have not been
made. Since compound interest is not deductible unless paid, this
provisions does not apply to forgiven yet unpaid compound
interest. The policy of the Act is that compound interest must be
paid in order to be deductible. The avoidance transactions here
constitute an abuse, having regard to that policy.
[62] I can
glean no identifiable policy from this argument. It is simply a
reiteration of what the Act itself says, that is, simple interest
can be deducted on a paid or payable basis and compound interest
must be paid to be deductible. That is not an underlying policy
statement, that is a summary of the legislation. I was not
referred by the Respondent to any materials that would assist me
in understanding why the government permitted the deduction of
simple interest on a payable basis and only permits the deduction
of compound interest on a paid basis. What is the policy? It is
not my role to speculate; it is the Respondent's role to
explain to me the clear and unambiguous policy. He has not done
so. I am therefore unable to find that there has been a misuse or
abuse as contemplated by subsection 245(4) of the Act.
Consequently, subsection 245(2) does not apply to the
Appellant's avoidance transactions.
[63] The
Appellant has most deliberately relied on the sanctity of legal
relationships, not to be impugned by the economic realities of a
situation, in achieving his goal. I am satisfied that indeed the
law supports his position, and while GAAR may be the ultimate
weapon for the government to undo such legal relationships, in
this instance the application of GAAR is simply ineffective.
[64] The
appeal is allowed and the assessments are referred back to the
Minister for reconsideration and reassessment on the basis that
the Appellant is entitled to deduct interest in the amounts of
$1,455,089 and $1,388,612 in respect of the 1996 and 1997
taxation years respectively, and is further entitled to deduct
non-capital losses from 1992 and 1993 in the sum $631,402.63 in
respect of the 1996 taxation year.
[65] The
Appellant is entitled to costs.
Signed at Ottawa, Canada this 30th day of April,
2002.
« Miller »
J.T.C.C.
COURT FILE
NO.:
2000-3636(IT)G
STYLE OF
CAUSE:
Frederick W. Hill v. Her Majesty the Queen
PLACE OF
HEARING:
Winnipeg, Manitoba
DATE OF
HEARING:
February 14, 2002
REASONS FOR JUDGMENT BY: The
Honourable Judge C.J. Miller
DATE OF
JUDGMENT:
April 30, 2002
APPEARANCES:
Counsel for the Appellant: Ian Gamble and Warren J.A.
Mitchell
Counsel for the
Respondent:
Robert Gosman and Jeff Pniowsky
COUNSEL OF RECORD:
For the
Appellant:
Name:
Warren J.A. Mitchell
Firm:
Thorsteinssons
Vancouver, British Columbia
For the
Respondent:
Morris Rosenberg
Deputy Attorney General of Canada
Ottawa, Canada
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