REASONS
FOR JUDGMENT
Lamarre A.C.J.
Introduction
[1]
During its taxation year ended December 31, 2003,
the appellant, George Weston Limited (GWL), received in respect of
the termination of cross‑currency basis swap contracts (swaps) proceeds
totalling CAD$316,932,896. In its income tax return for its 2003 taxation year,
GWL treated that amount as being on account of capital and reported a taxable
capital gain of CAD$158,466,448. The Minister of National Revenue (Minister)
reassessed GWL on the basis that the CAD$316,932,896 was on income account and
added to GWL’s income the full amount, hence the present appeal.
[2]
GWL is a Canadian publicly traded corporation
and the parent holding company of subsidiary corporations inside and outside Canada. A significant portion of the assets owned and businesses operated by the GWL
corporate group is in the United States.
[3]
In its Notice of Appeal, GWL stated that it had
entered into the swaps in order to preserve its consolidated balance sheet
equity and protect against Canadian dollar and United States dollar (USD)
foreign exchange fluctuations that would create volatility in GWL’s
consolidated balance sheet equity. In its submissions to the Court, GWL offered
some specifics. GWL indicated that it carried on various existing and newly acquired
bakery-related businesses in the United States, using US currency, through indirectly held subsidiaries (referred to as self-sustaining foreign
operations or USD Operations) and that this was the reason GWL was affected by the
Canadian dollar and USD exchange rate fluctuations. Those fluctuations affected
GWL’s consolidated equity, which in turn affected the debt to equity ratio.
Hence, they had an impact on the value of GWL’s direct capital investments in
other corporations in the GWL corporate group, and on GWL’s very capital
structure.
[4]
In the end, GWL took the position that, because
the Canadian dollar had appreciated relative to the USD between 2001 and 2003, the
proceeds it received in 2003 upon terminating the swaps it entered into in 2001
were a capital gain.
[5]
The respondent is of the view that the receipts
from the closing out of a derivative such as the swaps will be treated as being
on capital account for income tax purposes only if it can be shown that the
derivative is linked to an underlying transaction that is the purchase or sale
of a capital asset, the repayment of a debt denominated in a foreign currency
or the investment of idle capital funds, in accordance with what is referred to
in the case law as the “linkage principle”. In the Crown’s view, if the
derivative is not linked to such a transaction, the profit or loss on the closing
out of the derivative is considered either as resulting from speculation or, by
default, as being part of the ordinary business of the taxpayer, and is
therefore considered to have been received on income account. In the present
case, the respondent submits that, as the swaps were not linked to any
transaction or debt obligation of the appellant denominated in a foreign
currency that it entered into on its own account, the amount received by the
appellant when it closed out the swaps is considered to be part of the business
of the appellant and therefore a profit from its business that is taxable as
income.
Facts
[6]
The parties have agreed on many of the relevant
facts in a Partial Statement of Agreed Facts (Exhibit A-7), which is attached
at the end of my reasons for judgment.
Appellant’s interpretation of the
facts
[7]
The appellant gave its own assessment of the key
facts in its opening statement and in its written submissions. I will summarize
them below.
[8]
GWL is a large publicly traded Canadian holding
company that, at all relevant times, held direct and indirect subsidiaries that
carried on food processing or food distribution businesses in Canada and in the United States.
[9]
Prior to 2001, GWL carried on a bakery business
in the United States through a company called Weston Foods Inc. (WFI US)
and its subsidiaries. WFI US was an indirect subsidiary of the Canadian company
Weston Foods Inc. (WFI Can), which was in turn a direct subsidiary
of GWL.
[10]
In 2001, the GWL corporate group acquired
another mainly United States‑based bakery business called Bestfoods
Baking (Bestfoods) and its subsidiaries and related trademarks. This
acquisition drastically increased the GWL corporate group’s net investments in
USD Operations from approximately US$800 million to well in excess of
US$2 billion.
[11]
The Bestfoods acquisition was financed entirely
by debt, through loans from Canadian banks to GWL (CAD$2.1 billion and US$400 million).
As a result, in 2001, GWL’s debt to equity ratio rose well beyond its internal
corporate policy of 1:1 or lower. GWL invested the borrowed funds in its
subsidiaries, which then acquired Bestfoods for US$1.765 billion, as detailed
in the Partial Agreed Statement of Facts.
[12]
As a Canadian publicly traded company, GWL
prepared consolidated financial statements in Canadian dollars, in accordance
with generally accepted accounting principles (GAAP). In those
statements, it combined the assets and liabilities of its controlled
subsidiaries, including the USD Operations. When the value of its net
investments in the USD Operations was translated into Canadian dollars, the
fluctuations in the exchange rate affected the equity section of GWL’s
consolidated balance sheet (generally reflected in the “cumulative foreign currency
translation adjustment” account — hereinafter “currency translation account” or
“CTA”) in the sense that when the Canadian dollar appreciated relative to the
USD, GWL’s consolidated equity decreased, and when the Canadian dollar
depreciated, GWL’s consolidated equity increased.
[13]
Because the Canadian dollar was at historical
lows in 2001, GWL was concerned that it would appreciate substantially relative
to the USD, with the effect of eroding its consolidated equity and worsening
its debt to equity ratio, which in turn could affect its credit rating and cost
of capital.
[14]
After the acquisition of Bestfoods in 2001, the
investment in USD Operations exposed to currency risk increased from US$666 million
(US$816 million investment in WFI as at December 31, 2000, less US$150 million
in swaps entered into in 2000) to approximately US$2 billion.
[15]
To circumvent that risk, GWL decided to hedge
its increased USD currency risk. Following the closing of the Bestfoods
transaction, GWL entered into a number of swaps with various financial
institutions (the “counterparties”) for terms of mostly 10 to 15 years to
hedge, or protect against, currency fluctuations affecting the reported value
of the old and the newly acquired USD Operations (Exhibit A-7, par. 27, and
Transcript, vol. 1, page 211).
[16]
The USD notional value of the swaps closely
approximated the total net investments in the USD Operations that were exposed
to currency risk. According to Ms. Lisa Swartzman, who held the positions
of assistant treasurer, treasurer and vice president-treasurer of GWL at
various times during the years at issue, the swaps were entered into by GWL, as
opposed to subsidiaries, because the counterparties wanted to deal with the parent
corporation, and GWL had a higher credit rating than the subsidiaries, which
reduced the cost of swaps (Transcript, vol. 1, page 216).
[17]
The appellant submitted that the swaps were
entered into solely as a hedge. They mitigated GWL’s exposure to exchange rate
fluctuations because changes in the value of the swaps due to those
fluctuations varied inversely with, and therefore offset, changes in the
Canadian dollar translated value of the net investments in USD Operations due
to the same exchange rate fluctuations. Indeed, once the swaps were in place,
if the Canadian dollar appreciated, the increase in the value of the swaps would
offset the decrease in the Canadian dollar translated value of GWL’s net USD
investments in USD Operations on GWL’s consolidated balance sheet; conversely,
if the Canadian dollar depreciated, the decrease in the value of the swaps would
offset the increase in the Canadian dollar translated value of GWL’s net USD
investments in USD Operations on GWL’s consolidated balance sheet.
[18]
The appellant stated that GWL’s balance sheet
equity was protected and, because GWL was the ultimate parent company of the
USD Operations, the swaps protected the value of GWL’s investments in its own
subsidiaries.
[19]
In the consolidated financial statements, the
“swaps [were] identified as a hedge against foreign currency exchange rate
fluctuations on [GWL]’s [US] dollar denominated net investment in
self-sustaining foreign operations with realized and unrealized foreign
currency exchange rate adjustments on . . . swaps recorded in the cumulative
foreign currency translation adjustment.” (Notes to the 2002 consolidated
financial statements, Exhibit A-1, Tab 2, page 125). This was in conformity
with an internal memorandum issued on April 10, 2001, in which GWL recognized
that the Bestfoods purchase would directly expose GWL to increased risk, and in
which GWL designated the swaps as a hedge, indicating that if sufficient swaps
were entered into, the debt to equity ratio would be protected from exchange
rate fluctuations (Exhibit A-9, Tab 1).
[20]
As a matter of fact, GWL’s risk exposure was
commented on by credit agencies. On February 20, 2001, Standard & Poor’s
Global Credit Portal issued a report titled “[GWL] ‘A’ Ratings Placed on Credit
Watch Negative; Re: Purchase of Unilever Asset”, indicating that the Bestfoods
acquisition would be bank‑financed and that “[t]he net effect . . . [would]
be detrimental to Weston’s capital structure in light of . . . much higher
overall leverage” (Exhibit A-8).
[21]
Under GWL’s internal guidelines, the debt to equity
ratio was to be no worse than 1:1 (Transcript, vol. 1, page 80 and GWL Quarterly
Reports, Exhibit A-3, Tab 12, page 1021, and Tab 14, page 1050). After the
Bestfoods transaction, the ratio worsened to well beyond that desired ratio.
This was a particular concern because any devaluation in the USD would cause further
deterioration in the ratio, which could negatively affect the capital structure
if the credit rating were to drop. This was so because when the USD
depreciated, GWL’s indirect investment in USD Operations, expressed in Canadian
dollars, decreased in value, and consequently GWL’s direct investment in
subsidiaries, expressed in Canadian dollars, similarly decreased in value, with
a loss in balance sheet equity for GWL (Transcript, vol. 1, pages 167-168).
[22]
In 2002, certain of GWL’s indirect US subsidiaries sold some of the assets of the USD Operations for proceeds that were US$200
million higher than had been anticipated. As a result, GWL terminated
approximately US$200 million of the swaps so that the total USD notional
value of the swaps would not exceed what was needed to ensure that the USD
Operations were fully hedged. Retaining swaps that exceeded what was needed to
hedge the investment in USD Operations was contrary to GWL’s credit facilities
and corporate policy (testimony of Lisa Swartzman, Transcript, vol. 1, pages 221-222).
[23]
By 2003, the Canadian dollar had appreciated to
what GWL thought was a multi-year high against the USD, and GWL determined that
its currency risk was waning. GWL had refinanced or repaid its initial Bestfoods
acquisition financing and this, along with other measures, was expected to
cause its debt to equity ratio to fall. GWL needed funds to, among other
things, repurchase certain of its shares from its majority shareholder
(Transcript, vol. 1, pages 228-232 and 237‑238). Accordingly, GWL and its
counterparties agreed to terminate the swaps. Because the Canadian dollar had
appreciated between 2001 and 2003, the counterparties had to make net principal
repayments to GWL, and these make up the amount at issue in this appeal.
Facts added by the respondent
[24]
The respondent added the fact that, prior to
closing the Bestfoods transaction and entering into additional swaps in 2001,
the appellant held approximately US$150 million in swaps to offset part of the
net assets of GWL’s bakery business having a value of approximately US$816
million.
[25]
The respondent recognized that the appellant
entered into swaps after the acquisition of Bestfoods to offset fluctuations in
the currency translation account (CTA) in its consolidated balance
sheet. She also acknowledged that a negative adjustment to the account would
result in an increase in the debt to equity ratio and that a decrease in
shareholders’ equity would negatively influence that ratio and put the
appellant outside of its 1:1 guideline (Respondent’s Argument, par. 7).
[26]
The respondent pointed, however, to measures
taken by the appellant in 2002 and 2003 to decrease its liabilities through
refinancing its short‑term debt, increasing retained earnings through
profits of the operating subsidiaries, selling assets to pay down debts and
raising capital on the public markets through preference share issuance. These
activities positively affected the debt to equity ratio and resulted in the
appellant achieving its guideline figure in that regard (Respondent’s Argument,
par. 8).
[27]
The respondent added that, commencing in the
first quarter of 2003, the Canadian dollar appreciated against the USD and the
rate of exchange was significantly higher in 2003 than it had been in October
2001 when the swaps were entered into by the appellant (Respondent’s Argument,
par. 9).
[28]
According to the respondent, in 2003, the
appellant made a business decision to terminate the swaps and realized a profit
of close to CAD$317 million, being the amount at issue in this appeal. The
Bestfoods assets that were exposed to fluctuations in the CTA were not sold in
2003. It was only in January 2009 that GWL’s indirect subsidiary Dunedin
Holdings S.a.r.l, a Luxembourg company, sold some of the Bestfoods assets
(Transcript, vol. 1, page 152, and Exhibit A-3, Tab 9, page 959).
[29]
The respondent pointed out that the variation in
the CTA is a notional amount which is not included in the income statement of
the parent company. Relying on her accounting expert, Professor Chlala, she stated
that foreign exchange translation risk exists because of the requirement under
GAAP to translate the value of the net assets of subsidiaries into Canadian
dollars for consolidated reporting purposes. According to the respondent,
foreign exchange “translation” risk has no impact on the cash flow or earnings
of a company. It is not reflected in the legal entity financial statements,
that is, the unconsolidated financial statements, of GWL. In contrast, foreign
exchange “transaction” risk arises from a legal obligation denominated in a foreign
currency and does have an impact on the cash flow or earnings of a company.
That risk is reflected in both the unconsolidated and the consolidated
financial statements (Professor Chlala’s expert report, Exhibit R-1, pages
21-24 and 30).
[30]
Thus, the unconsolidated financial statements
filed for Canadian income tax purposes reflect only the income earned and the
assets and liabilities held directly by the appellant. Thus, the appellant’s
list of investments in the unconsolidated financial statements does not include
shares in the capital of Bestfoods, as the appellant did not acquire the shares
of that company. The shares of Bestfoods were acquired by Weston Acquisition
Inc (WAI). Only the investment in a direct subsidiary is reflected, at
historic cost (a figure that is therefore not subject to any fluctuation) in
Canadian dollars, in the legal entity financial statements.
Issues
[31]
The appellant raised three questions to be
addressed in order to determine whether the proceeds received from unwinding
the swaps are to be characterized as capital or as business income.
- Were
the swaps entered into as a hedge?
- If
so, what was the character of the item that prompted the hedge and was that
item capital in nature so that the proceeds derived from the swaps are to be
treated as being on capital account?
- Regardless
of whether the swaps constituted a hedge, did the swaps relate to GWL’s capital
structure such that the proceeds are on capital account or, instead, were the
swaps part of GWL’s income earning process such that the proceeds are on income
account?
[32]
The respondent advanced three arguments in
support of the determination that the profit received in the amount of CAD$316,932,869
is on income account:
- The
swaps were not linked to an underlying capital transaction denominated in a
foreign currency or a debt obligation denominated in a foreign currency that
exposed the appellant to foreign currency risk. Accordingly, the profit
received on the termination of the swaps is considered to be part of the
business income of the appellant;
- In
deciding to close out the swaps when they were “in the money” in the hands of
the appellant (meaning that the Canadian dollar had strengthened at the time of
termination of the swaps and the appellant received money from the counterparties),
the appellant was speculating in currency or meeting a business need for cash. Thus,
the profit received is income from an adventure in the nature of trade; and
- Swaps
are not capital property and the payment received by the appellant on their
termination is not proceeds of disposition of a capital property.
Appellant’s arguments
i) The swaps were
entered into as a hedge
[33]
The appellant stated that there is no reasonable
basis for the respondent to deny that the swaps constituted a hedge. To so
conclude, it referred to the following points from the evidence:
- The
respondent agreed in her examination for discovery that GWL did not enter into
the swaps for speculative purposes (Exhibit A-13, Tab 1, Undertaking Response
13).
- GWL
had a formal derivative policy and GWL’s credit facilities prohibited it from
speculating in derivatives (Transcript, vol. 1, pages 51-54, and
Credit Agreement with various lenders, Exhibit A‑4, Tab 22, page 1230,
article 6.6 Hedging Agreements).
- GWL’s
contemporaneous annual reports publicly confirmed that GWL used swaps as a
hedge and not for speculative purposes (Exhibit A-1, Tab 1, page 51, Tab 2, page
125 and Tab 3, pages 223-4).
- The
relevant corporate records clearly and consistently indicated that GWL intended
to and did enter into the swaps to hedge the risk associated with the
investment in USD Operations, which risk was reflected in the CTA (Exhibit A-9,
Tabs 1-8).
- The
decision to enter into the swaps was made in a careful and systematic manner,
having regard to the anticipated volatility in, and erosion of, the CTA as a
result of the currency risk associated with the investment in USD Operations
and the effect of this currency risk on GWL’s debt to equity ratio (Exhibit A-9,
Tabs 3 and 6 and testimony of Richard Mavrinac, Senior Vice-president, Finance
of GWL in 2001, and CFO of GWL in 2002-2003, and of Lisa Swartzman, Transcript,
vol. 1, pages 59-61 and 167-179).
- Ms. Joyce
Frost, who provided expert evidence on the commercial meaning of a hedge,
explained that the swaps were inappropriate for use as a speculative trading
instrument (Exhibit A-11, Riverside Report, page 24, par. 73 d.).
- Ms. Frost
opined that, from a commercial perspective, the swaps “were hedges that
mitigated the foreign exchange risk imbedded in GWL’s USD sensitive net assets”
(Exhibit A-11, Riverside Report, page 9, par. 31).
- The
respondent has agreed that GWL was not in the business of entering into and
terminating swaps (Exhibit A-13, Tab 1, Undertaking Response 3).
- The
notional amount of the swaps was determined on the basis of the amount needed
to correspond with the total value of the investment in USD Operations that was
subject to currency risk. GWL took steps to ensure that it would not own swaps
in excess of what was needed to hedge that value (Partial Statement of Agreed
Facts, par. 20-21 and 33, and testimony of Ms. Swartzman, Transcript, vol.
1, pages 221-222).
- The
reason the swaps were terminated was the conclusion that the currency risk
associated with the investment in USD Operations was waning and that GWL’s debt
to equity ratio would return to desired levels independently of the swaps
(testimony of Mr. Mavrinac and Ms. Swartzman, Transcript, vol. 1, pages
80-81 and 228-232).
- From
an accounting perspective, the swaps were treated and properly recorded as a
hedge in GWL’s consolidated financial statements in accordance with GAAP
(Expert Accounting Report prepared by Professor Daniel B. Thornton, Exhibit
A-12, page 7, par. 14).
[34]
The appellant then argued that it entered into
the swaps to hedge the foreign exchange risk with respect to its net investment
in foreign operations, which risk is primarily borne by it, the parent company.
It did so because volatility in equity due to changes in foreign exchange rates
is not favourably regarded by equity investors or credit-rating agencies. In
addition, declines in equity caused by foreign exchange losses could result in
a violation of a loan covenant or encourage investors to sell the stock
(testimony of Ms. Frost and Exhibit A-11, Riverside Report, pages 10 and 13,
par. 34, 35 and 40).
[35]
The appellant added that, had GWL not entered
into the swaps to hedge the increased risk, a devaluation of the USD would have
lowered the equity figure on its consolidated balance sheet. The attendant
results would have been an erosion of GWL’s debt to equity ratio, a reduction
in its credit rating, a deterioration of its capital structure and a negative
impact on GWL’s share price. The experts called by the appellant concluded that
the underlying USD net investments were highly and directly sensitive to GWL’s
currency risk (Riverside Report (Ms. Frost), Exhibit A‑11, pages 10,
13, 17-18, par. 34, 53 and 54, and Thornton Report, Exhibit A-12, par. 73-75).
[36]
Absent a definition of a hedge in the Income
Tax Act (ITA) (except in section 20.3 in the context of weak
currency loans), the appellant analyzed the meaning of hedge in its commercial
and accounting sense as well as the meaning it has been given in the case law
that I will review in my analysis. It concluded that GWL genuinely had
investments exposed to currency risk and that it hedged that risk by entering
into the swaps and explicitly designating those swaps, in its consolidated
financial statements, as hedges of GWL’s investment in self‑sustaining
foreign operations.
ii) The item that
prompted the hedge was capital in nature and therefore the proceeds from
unwinding the hedge were to be treated as being on capital account
[37]
The appellant, unlike the respondent, is of the
view that the underlying item to which the derivative (the swaps) relates does
not necessarily need to be a separate transaction when it is the derivative
itself, as is the case here, that directly gives rise to the gain or loss. In
this case, the appellant argued that the evidence shows a strong link between
the swaps and the investment in the USD Operations. This is confirmed by the
GWL 2001 and 2003 presentation materials (Exhibit A-9, Tabs 3 and 6), which
show no intention to relate the swaps to the business operations or to make a
profit in the financial markets.
[38]
Further, the swaps were entered into
contemporaneously with the period in which the Bestfoods purchase occurred,
which purchase greatly increased the investment in USD Operations and,
accordingly, GWL’s currency risk. Most of the swaps were part of GWL’s planning
for the Bestfoods acquisition and were implemented in connection with, and as a
result of, that important acquisition. The amount of the swaps entered into
correlated directly with the investment in USD Operations through the matching,
as closely as possible, of the notional amount of the swaps with the amount of GWL’s
net investment in self-sustaining US operations (Thornton Report, Exhibit A-12,
par. 19). There was a sufficient correlation between the swaps and the
investment that was subject to currency risk. Further, the fact that the swaps
were terminated in 2003 does not retroactively change GWL’s intention when
entering into the swaps in 2001. Indeed, GWL only intended to hedge the USD
Operations while the associated currency risk exceeded acceptable levels.
[39]
Finally, the appellant stated that the
investment in USD Operations, the item that prompted the hedge, was capital in
nature and, accordingly, the proceeds from unwinding the swaps are to be
treated as being on capital account. According to the appellant, this is true
whether one takes the approach that it is a direct investment for GWL or
whether one views it as an indirect investment.
[40]
On the one hand, one may consider the value of
GWL’s direct investment in companies in the GWL corporate group (that directly
or indirectly own the USD Operations), which necessarily fluctuates according
to the value of the investment in USD Operations. From this perspective, it is
the value of those USD Operations that is used to determine the amount of the
hedge required to protect the value of GWL’s direct capital investment.
[41]
On the other hand, there is the approach under
which the USD Operations constitute a capital investment made by indirect GWL
subsidiaries, all of which in the end are wholly owned by GWL at the top of the
corporate chain. Changes in the Canadian dollar value of those indirect
subsidiaries have a direct impact on GWL’s capital structure (debt to equity
ratio). From this perspective, GWL is hedging an indirect capital investment
that has a direct impact on GWL’s capital structure.
[42]
The appellant submitted that, whatever approach
is taken, GWL, as a holding company, held subsidiaries as a capital investment.
Mr. Mavrinac testified that GWL acquired Bestfoods with the intention of
holding it long-term (with the exception of one component of the business that
was intended to be sold), which was in line with GWL’s corporate history of
holding Loblaws and its US baking assets for the long term (Transcript, vol. 1,
page 61). GWL financed its subsidiaries through loans or equity investments
which were in turn used to acquire control of the USD Operations. Those outlays
are of a capital nature (Neonex International Ltd. v. The Queen, [1978]
C.T.C. 485; 78 DTC 6339; Stewart & Morrison Ltd. v. M.N.R., [1974] S.C.R.
477). GWL did not speculate and it was not in the business of acquiring and
terminating swaps.
[43]
The appellant also questioned the Canada Revenue
Agency (CRA) approach according to which the linkage test demands the
existence of a sale or proposed sale of an underlying item owned directly by
the taxpayer. This restrictive view precludes the possibility of hedging an
investment that is either (i) not intended to be sold or (ii) owned indirectly
through subsidiaries.
[44]
The appellant submitted that this restrictive
view has no legal basis and makes no commercial sense. Among the case law
relied upon by the respondent, the appellant referred to Shell Canada Ltd.
v. Canada, [1999] 3 S.C.R. 622. In the appellant’s view, the Supreme Court
of Canada (SCC) made therein no statement consistent with the CRA’s position.
On the contrary, that case, according to the appellant, stands for the
proposition that hedge proceeds will be on capital account if the item being
hedged (whether it is an asset, a liability or a transaction) is a capital
item. Further, in Neonex, supra, the Federal Court of Appeal
attributed the capital character of the subsidiary’s capital asset to the
parent company’s investment in its subsidiary. In that case, it was held that a
loan made solely for the purpose of replenishing the working capital of a
subsidiary which had acquired control of another company was a capital
transaction.
iii) Whether or not
the swaps constitute a hedge, the proceeds from their termination were part of
GWL’s capital structure and are on capital account
[45]
The appellant examined the factors considered in
the case law when the courts are seeking to characterize an “unusual” amount
either as being part of the capital structure or as being part of the income-earning
process. It concluded that the proceeds from the swaps were received as part of
GWL’s capital structure and therefore were on capital account.
[46]
The appellant submitted that the swap proceeds were
analogous to awards of damages and to contract termination payments. It argued
that such proceeds are on capital account where the underlying item is more
closely connected to the capital structure than to the income-earning process (Tsiaprailis
v. Canada, 2005 SCC 8, [2005] 1 S.C.R. 113 at par. 7 and 15 and Imperial
Tobacco Canada Ltd. v. The Queen, 2011 FCA 308, 2012 DTC 5003 at par. 29).
[47]
More generally, the appellant outlined the
capital gain versus income test outside of the derivative context. The Supreme
Court of Canada has framed the test as follows: “were [the] sums expended on
the structure within which the profits were to be earned or were they part of
the money-earning process?” (Johns-Manville Canada v. The Queen, [1985] 2 S.C.R. 46 at 57 (Lexum at par. 14), quoting from the
Privy Council decision in B.P. Australia Ltd v. Comr. of Taxation of
the Commonwealth of Australia, [1966] A.C. 224). Additionally, the SCC in Ikea
Ltd. v. Canada, [1998] 1 S.C.R. 196, provided further guidance on the
distinction between income and capital gains, in the context of a tenant
inducement payment. The Court found that the payment was “clearly received as
part of ordinary business operations and was, in fact, inextricably linked to
such operations” (par. 24, 25, 30 and 33).
[48]
The appellant stated that the courts often
consider the following factors to distinguish income from capital: (1)
intention, (2) benefit, (3) duration, (4) recurrence, and (5) financial reporting
(Vern Krishna, The Fundamentals of Canadian Income Tax (Taxnet Pro, 2014),
ch. 7.I.D, and see Interpretation Bulletin IT-479R, “Transactions in Securities”
(February 1984)). A review of the case law under each heading was presented,
which I will not summarize here.
[49]
The appellant submitted that the common law
often looks to an underlying item when seeking to characterize a receipt as
income or capital for tax purposes. Under this test, the appellant argued, the
same conclusion as above is reached; the swap proceeds were received in
connection with GWL’s capital structure and were therefore on capital account.
The respondent’s arguments
[50]
The respondent submitted that the character of
hedging gains or losses is determined by reference to the underlying
transaction to which the hedge relates. If the hedge cannot be linked to an
underlying transaction that is on capital account, it must be considered as
being on income account.
[51]
The respondent acknowledged that as a result of
the requirement to prepare consolidated financial statements, the translation
of the financial statements of GWL’s subsidiaries from their domestic currency
into Canadian dollars created a translation risk that was recorded in the CTA,
which had a direct impact on the consolidated shareholders’ equity. However,
she is of the view that the decision to enter into the swaps was a management
decision flowing from concerns that a negative fluctuation in the CTA could
have a material impact on the debt to equity ratio that could not be absorbed
by the balance sheet alone. As a consequence of the designation of the swaps as
hedges under GAAP hedge accounting rules, the impact that foreign exchange
fluctuations had on the swaps was the opposite of the impact foreign exchange
fluctuations had on the translation of the net assets. The swaps thus stabilized
the CTA balance while GWL went about implementing other methods to bring its
debt to equity ratio back to its 1:1 internal guideline. During that transition
period, they ensured creditworthiness, which had an impact on the cost of
borrowing, and all of these decisions were part of the ordinary business of
managing a public company.
[52]
In the respondent’s view, the fact that the
appellant used swaps to hedge the translation account and applied hedge
accounting in its consolidated financial statements does not assist in the
determination of whether the swaps were a hedge for tax purposes. Hedge
accounting is a choice that taxpayers make in their financial statements. For
tax purposes, she submitted, whether the swaps were a hedge or not depends on
whether there is interconnection or linkage with an underlying transaction
undertaken by the appellant on its own account.
[53]
In this case, while the appellant funded the
acquisition with a borrowing on its own account, the swaps were not linked to
this borrowing and the borrowing did not give rise to any foreign exchange
exposure. The appellant made a series of loans and equity investments
denominated in Canadian dollars to four of its subsidiaries.
[54]
For income tax purposes, submitted the
respondent, it is not sufficient to hedge the net investment in foreign
subsidiaries through a hedge of the CTA without there being an intention to
sell that investment, as there is no offsetting position against which any of
the gains or losses arising from the contract could be matched. The respondent
added that the appellant cannot, for tax purposes, link its derivative to the
risk of another taxpayer. She concluded that here there is no hedge for income
tax purposes.
[55]
Further, she argued that the swaps were not
linked to the acquisition of Bestfoods. The value of the swaps exceeded the
value of the Bestfoods transaction but matched the combined value of the Bestfoods
transaction and the pre-existing US bakery business. Hence, the appellant could
not, for tax purposes, link the swaps with any foreign currency transaction or
a debt obligation in a foreign currency.
[56]
The respondent, referring to Salada Foods
Ltd. v. The Queen, 74 DTC 6171 (FCTD) and Saskferco Products ULC. v. The
Queen, 2008 FCA 297, 386 N.R. 276, stated that the courts have
rejected the appellant’s argument. The hedging of net investments from an
accounting perspective, that is, the hedging of translation exposure, is simply
not sufficiently linked to the shares or the assets of a subsidiary for it to
be possible to obtain capital account treatment. Such translation hedging is
geared toward the net investment of the parent in a subsidiary on a book basis
(including undistributed earnings) and not toward transaction exposure (Shawn
D. Porter and Kenneth J.A. Vallillee, “Tax and Accounting Aspects of Treasury
Operations”, Report of Proceedings of the Fifty‑Second Tax Conference,
2000 Conference Report (Toronto: Canadian Tax Foundation, 2001), 20:1-51 at
20:26).
[57]
The respondent’s position is that, while it is
possible for a taxpayer to establish a linkage between a currency-hedging
contract and the net investment in a foreign subsidiary, a linkage for tax
purposes would only be made out if the taxpayer had intended to sell the
subsidiary, the subsidiary was directly held and it was likely that the sale would
occur. Here, the swaps were not linked to any underlying capital transaction
that exposed the appellant to foreign exchange risk.
[58]
Further, the appellant did not have a foreign
exchange risk from any of its own debt obligations as the CAD$2.1 billion
loan was denominated and repayable in Canadian dollars.
[59]
The swaps were never intended to be in place for
a long time, but were only temporary in that the appellant took other measures
to bring its debt to equity ratio back to 1:1. Thus, the swaps did not provide
long-term benefits.
[60]
Moreover, according to the respondent, once the
board of directors decided to terminate the swaps and use the cash for another
purpose, there was a change of intention from hedging the CTA to speculation.
Having predicted that the Canadian dollar would not strengthen and that the
balance sheet could absorb any fluctuation in the CTA, the appellant determined
that it was an opportune time to crystallize its position and it closed out the
swaps at a time when there was a business need for cash. Accordingly, the
profit received was income from an adventure in the nature of trade.
Analysis
Preliminary issue
Admissibility of the appellant’s expert
evidence, presented by Ms. Joyce Frost, on the use of derivatives to hedge
commercial and financial risk
[61]
The respondent objected to Ms. Frost’s
testimony on the basis that it was highly prejudicial (in that her opinion was
based on her anecdotal experience from working in risk management for 25
years), was not relevant to the issue to be decided, was not necessary to
assist the trier of fact in analyzing evidence that is technical in nature and
was subject to exclusionary rules (R. v. Mohan, [1994] 2 S.C.R. 9
at page 20; R. v. Sekhon, [2014] 1 S.C.R. 272).
[62]
I overruled that objection. I did not agree that
Ms. Frost’s opinion was anecdotal. Her opinion based on 25 years’ work
experience in risk management cannot be compared to a police officer testifying
as to the mens rea of a particular defendant in a criminal matter as was
the case in Sekhon, referred to by the respondent. With respect to
relevance and necessity, this is a case in which I find it particularly useful
to have the insight of an expert in the risk management field as it is directly
linked to one of the issues between the parties: i.e., whether or not the swaps
qualify as a hedge. Hedge is not defined in the ITA in the context of a
situation such as that existing in this particular case; it is therefore
appropriate to consider, among other things, the commercial context of hedging,
keeping in mind that well-accepted principles of commercial trading are
acceptable as guidance in this regard (Symes v. Canada, [1993] 4 S.C.R.
695, par. 42-43). I also note that expert testimony on industry practice and on
accounting principles related thereto was accepted as being relevant in Echo
Bay Mines Ltd. v. Canada, 1992 CarswellNat 323, at par. 15-17, [1992] 3
F.C. 707 at pages 713-14, where the court had to decide, among others things,
whether forward sales contracts for silver were a hedge designed to reduce the
risk of wide price fluctuations.
[63]
Further, I do not find that Ms. Frost’s
testimony sought to usurp my role as a trier of fact as I will rely on her
expertise only to better understand the hedge financing world, which in itself
is not necessarily an area of common knowledge. Finally, I do not find that Ms.
Frost’s evidence is subject to the exclusionary rules invoked by the
respondent. I agree with the appellant that her report addresses the commercial
context surrounding the use of derivatives and that her testimony is relevant
to the issue before me. Accordingly, I do not find that her opinion violates subsection
145(7) of the Tax Court of Canada Rules (General Procedure) (Rules),
since I do not agree with the respondent that her testimony is not related to
an issue in this appeal. With respect to subsection 98(3), also invoked by the
respondent, which relates to the continuous disclosure obligation, the
appellant informed the Court that Ms. Frost’s report was sent to the
respondent three months before trial, and the respondent cannot now claim that
the appellant failed to comply with the disclosure of information requirement
under that provision.
Existence of a hedge
[64]
There is no definition of a hedge in the ITA,
except in the context of weak currency debts in subsection 20.3(1). Although
not applicable here, that definition does provide indirect guidance. It
requires that the derivative be entered into primarily to reduce the taxpayer’s
risk, and that the taxpayer properly designate the derivative as a hedge.
[65]
In her written submissions, at paragraph 19, the
respondent alludes to the definition of a hedge in GWL’s Derivatives Policy, which
states that a hedge is an instrument or strategy used to offset the risks of an
asset, liability, income or expense by taking an opposing position (Exhibit
A-6, Tab 62, page 1840).
[66]
The appellant provided some commercial
definitions of a hedge. It is defined as being, among other things, a strategy
used to offset investment risk (Dictionary of Finance and Investment Terms,
5th ed., (Barron’s Financial Guides), referred to in the Riverside Report,
Exhibit A-11, page 8, par. 26 and footnote 1). In her report, Ms. Frost
defined a hedge as an action or an intentional inaction that results in an
outcome that limits or eliminates negative outcomes of risk (Exhibit A-11,
page 8, par. 25). She stated that, in the parlance of hedging, there is the
hedge and there is the hedged item. The hedge is the instrument (the derivative
contract) and the hedged item is the element of the organization that is
negatively affected by the risk (e.g., cash flow, revenues or expenses, value
of assets, liabilities or equity)(Exhibit A-11, page 8, par. 28).
[67]
In Placer Dome Canada Ltd. v. Ontario
(Minister of Finance), [2006] 1 S.C.R. 715 at page 719, par. 1,
the Supreme Court of Canada states that it was called upon to interpret the
definition of “hedging” in the Mining Tax Act of Ontario. It was not a
capital gain versus income case. Rather, the Court had to decide whether
profits derived from mining operation “hedging” programs designed to manage the
risk associated with fluctuations in the spot price of gold were taxable under
that Act.
[68]
Nonetheless, the Supreme Court made some
comments that are interesting for the purposes of the present case. It characterized
hedging, as it is commonly understood, as referring to transactions that offset
financial risk, such as price risk or foreign exchange risk. At page 731,
paragraph 29, the Court gave a brief overview of hedging as it is understood
under GAAP. Generally speaking, financial derivatives are contracts whose value
is based on the value of an underlying asset, reference rate, or index. There
are essentially two reasons for entering into such a contract — to
speculate or to hedge. A transaction is a hedge where the party to it genuinely
has assets or liabilities exposed to market fluctuations, while speculation is
“the degree to which a hedger engages in derivatives transactions with a
notional value in excess of its actual risk exposure”: see Brent W. Kraus, “The
Use and Regulation of Derivative Financial Products in Canada” (1999), 9 W.R.L.S.I.
31, at page 38.
[69]
Further, at page 732, paragraph 31, the Supreme
Court stated that, under GAAP, derivative contracts may be settled not only by
physical delivery, but also by cash settlement or offsetting contracts. The
Supreme Court reiterated, at page 741, paragraph 49, that although
well-accepted business and accounting principles must play a subsidiary role to
clear rules of law, “it would be unwise for the law to eschew the valuable
guidance offered by well-established business principles” where statutory
definitions are absent or incomplete: see Canderel Ltd. v. Canada,
[1998] 1 S.C.R. 147, at paragraph 35.
[70]
In my view, the appellant has demonstrated that
the swaps were entered into as a hedge and not with the intent to speculate.
The reasons given above by the appellant in its submissions (par. 33 and 42 of these
Reasons) are sufficiently convincing. I find it clear from the evidence that it
was the Bestfoods transaction that triggered the decision to protect the
reported value of all the USD Operations against currency fluctuations. Indeed,
that was a major transaction. According to Ms. Frost, “[t]he Bestfoods
acquisition represented a 26% increase in GWL’s total assets and a doubling of
its total indebtedness” (Riverside Report, page 19, par. 57). This transaction
led to a significant increase in the USD investments exposed to currency risk.
In fact, the value of those investments rose from US$666 million to US$2.031
billion, which translates, according to my own calculation, into an increase of
over 200%. The USD notional value of the swaps closely approximated the total
net investments in the USD Operations that were exposed to currency risk.
[71]
The fact that the swaps were not all carried out
contemporaneously with the Bestfoods acquisition is not fatal as they were
entered into over a period that was fairly close to the transaction date (Atlantic
Sugar Refineries Ltd. v. Minister of National Revenue, [1949] S.C.R. 706,
at pages 711-712).
[72]
Further, the fact that the swaps were entered
into by the appellant in relation to the USD Operations conducted by its
subsidiaries does not alter my conclusion that the swaps constituted a hedge
for the appellant (Echo Bay Mines, supra, at pages 730-31 F.C., par. 61
CarswellNat). The appellant has drawn a parallel with the situation in Neonex,
supra. The Federal Court of Appeal found in that case that a loan made
solely for the purpose of replenishing the working capital of a subsidiary
which had acquired control of another company was a capital transaction. The
parent had borrowed money in USD and lent the money back to its subsidiary.
When the parent repaid its USD loan, it made a foreign exchange gain which was
determined to be on capital account by the Court. In reaching that conclusion,
the Court attributed the character of the subsidiary’s capital asset to the
parent company’s loan to its subsidiary.
[73]
Here, I find that the evidence establishes that
the appellant, in entering into the swaps, was acting in close consultation
with and on behalf of its subsidiaries in order to protect the equity of the
whole Weston group, as disclosed in the consolidated financial statements. As stated
by Ms. Frost and Mr. Thornton, the underlying USD net investments
were in a direct way highly sensitive to GWL’s currency risk. Indeed, I agree
with the appellant that the fluctuations in the USD investments affected GWL’s
own capital structure and had an impact on the value of GWL’s direct
investments in its subsidiaries.
[74]
The respondent submitted that the foreign
exchange translation risk existed only because of the GAAP requirements that
the value of the net assets of the subsidiaries be translated into Canadian
dollars for consolidated reporting purposes. In her view, that translation risk
had no impact on the cash flow or earnings of the appellant. This view does not
seem to be shared by Ms. Frost, whose opinion was that, although there was
no periodic cash effect, GWL still faced the risk that changes in foreign
exchange rates could have a negative impact on the book value of its equity,
and this risk could be particularly harmful to GWL’s stakeholders. In her
opinion, volatility in equity due to changes in foreign exchange rates is not
favourably regarded by equity investors or credit‑rating agencies (par. 34
of her report, Exhibit A-11). I infer from this that the translation risk referred
to by the respondent did have an impact on the cash flow earnings of the
appellant, which might have lost its borrowing capacity had it not put in place
a hedge to mitigate that risk. As a matter of fact, Standard and Poor’s raised
a red flag with regard to GWL’s credit rating after GWL’s decision to use bank
financing for the acquisition of Bestfoods.
[75]
Further, the respondent’s argument fails to
recognize that a real risk existed in GWL’s business after the Bestfoods
acquisition, regardless of any GAAP requirements or “notional” reporting prior
to the termination of the swaps. That risk was reflected in the CTA, in
accordance with GAAP, but that does not change the fact that GWL was exposed to
currency risk associated with an increasing debt to equity ratio as a result of
its expanded indirect holdings in US assets. That risk led to tangible
consequences as detailed by Ms. Frost and as evidenced by Standard & Poor’s
credit watch discussed above. This caused management to hedge the risk using
swaps which were directly tied to the value of GWL’s US assets.
Characterization of the hedging gain
[76]
The respondent submitted that in the absence of
any linkage to a capital transaction or a debt obligation denominated in a
foreign currency that exposed the appellant to foreign currency risk, the
foreign exchange gain is considered to be part of business income. She added
that, for income tax purposes, it is not sufficient to hedge the net investment
in foreign subsidiaries through a hedge of the CTA without having an intention
to sell that investment, as there is no offsetting position against which any
of the gains or losses arising from the contract could be matched.
[77]
The respondent relied first on Atlantic Sugar
Refineries Ltd., supra, and on Tip Top Tailors Ltd. v. Minister
of National Revenue, [1957] S.C.R. 703. In both cases, the Supreme Court of
Canada held that profits received from derivatives linked to the purchase or
sale of commodities or supplies (raw sugar in the first case and cloth in the
second) were connected with the business and had to be treated as business
income. Here, GWL does not dispute that earnings from derivatives linked to
commodities are to be treated as business income. In the present case, the
swaps were not linked to the purchase or sale of commodities. They were entered
into to stabilize the value of the USD assets exposed to currency risk on the
balance sheet.
[78]
The respondent then referred to Salada Foods,
supra. In that case, Salada Foods derived a profit from the
purchase and sale of foreign exchange through a forward sale contract with a
bank. Salada Foods argued that the forward sale contract was entered into for
the sole purpose of protecting its investment in its United Kingdom (UK)
subsidiaries and that the gain was offset by the loss in that investment as a
result of the devaluation of the pound. The gain therefore, according to Salada
Foods, was on capital account and did not result from either a transaction
entered into in the course of its trading operations or an adventure in the
nature of trade. The Crown pointed out that there was no realized loss shown on
the company’s books and that it was a notional loss only. The Federal Court
came to the conclusion that there was little or no relationship between the
gain received by Salada Foods on its forward sale contract and its actual
investment loss as a result of the devaluation of the pound. In reaching that
conclusion, the Court observed that Salada Foods did not provide evidence
linking the proceeds to the capital investment in the subsidiaries. The Court
also concluded that Salada Foods was simply buying and reselling currency at a
profit, and it was admitted by the company that the transaction was wholly
speculative (page 6175).
[79]
As pointed out by GWL, the Court in Salada
Foods, supra, was influenced by the fact that Salada Foods was regularly
speculating in currency. Further, the Court observed that there was no evidence
as to the value of the assets and therefore there was no sufficient link
between the derivatives and the capital investment. The Court did not really
say that it was impossible to hedge a capital asset.
[80]
In Shell, supra, also relied upon
by the respondent, Shell entered into a foreign currency debt obligation in a
weak currency. The borrowed funds were used for capital purposes. At the same
time, Shell entered into a forward exchange contract in the same amount as the
principal amount of the debt to hedge its exposure to foreign exchange
fluctuations upon the repayment of the debt. Shell realized a foreign exchange
gain on the repayment of the debt. It also realized a foreign exchange gain on
the settlement of the forward exchange contract when it repaid the debt.
Although the gain on the closing out of the forward exchange contract occurred
when Shell repaid the capital debt, the Supreme Court of Canada accepted the
fact that there were two separate foreign exchange gains arising from two
distinct transactions with two separate arm’s length parties (page 652, par. 65).
The Court characterized the gain on the repayment of the debt as being on capital
account because the purpose of the underlying transaction, the debenture agreements,
was to provide Shell with working capital for a five-year term. It was a
capital debt obligation (page 654, par. 69). With respect to the
characterization of the foreign exchange gain arising from the hedging contract
as being on income or on capital account, the Court stated that it depended on
the characterization of the debt obligation to which the hedge related (page
654, par. 70). The Court noted that Shell would not have entered into the debenture
agreements in the absence of the forward exchange contract. Because the gain on
the debenture agreements was on capital account, so also was the gain on the forward
exchange contract.
[81]
The appellant pointed out that the Supreme Court
of Canada did not say that the derivative must necessarily be linked to a
separate transaction, as submitted by the respondent in the present case.
Rather, argued the appellant, the Supreme Court said that, in order to
characterize the proceeds from a derivative transaction, one needs to identify
the underlying item that created the risk (in the Shell case, the debt
obligation) to which the derivative relates (which item does not necessarily
need to be a transaction). I agree. The Supreme Court recognized the existence
of two transactions but did not say that the gain or loss on a derivative
transaction must necessarily be linked to a gain or loss on another transaction
as argued by the respondent. What is important is to identify the risk to which
the derivative transaction is related and to determine whether the related item
at risk (be it a debt obligation or foreign investments) is capital or income
in nature. I am therefore prepared to accept the appellant’s proposition that,
if it is found that the derivative was used to hedge a capital investment, any
gain derived from the derivative will be on capital account.
[82]
The respondent also referred to the recent decision
of the Federal Court of Appeal in Saskferco Products ULC v. The Queen, supra,
in which the Court rejected the application of hedge accounting principles so
as to cancel out, for tax purposes, Saskferco’s foreign currency losses and
gains on its loan repayments and revenue from US sales respectively (par. 6).
In that case, Saskferco claimed that a USD loan used to finance the
construction of a plant was obtained as a natural hedge of USD sales revenues.
Saskferco anticipated that the USD revenues would be used to repay the USD
loan. The decline in the Canadian dollar against the USD resulted in foreign
currency losses on Saskferco’s principal repayments on the USD loan. At the
same time, Saskferco had foreign currency gains on its USD sales revenues. The
Court held that the underlying transaction was the foreign currency denominated
loan (and not the hedging of USD sales revenues) and determined that the
foreign exchange losses were on capital account. The Court noted in that case
that Saskferco’s loan had an independent commercial purpose (financing the
construction of the plant, a capital asset) that was unrelated to the contracts
of sale (par. 24 and 29).
[83]
The appellant pointed out that in the Saskferco
case, there was no correlation between the hedge transaction (the USD loan) and
the item said to be hedged, the USD sales revenue. In contrast, in the present
case, submitted the appellant, the swaps were not an independent commercial
transaction and there was no lack of correlation.
[84]
The respondent also relied on Ethicon Sutures
Ltd. v. The Queen, 85 DTC 5290, [1985] 2 C.T.C. 6 (FCTD), as a further
application of the linkage principle. In that case, the taxpayer realized a
foreign currency gain on funds placed in USD term deposits. Some of the funds
went to capital expenditures and some were used for inventory purchases. The
Court said that it is necessary to look at the nature of the underlying transaction
which gives rise to the gain in order to determine whether it is on capital or on
income account (page 5293 DTC, 10 C.T.C.). The Court found that the primary
intention of the taxpayer was to use the disputed funds for a capital purpose
but that a secondary intention existed to have funds available to make
inventory payments (pages 5292-93 and 5294 DTC, 8-9 and 11 C.T.C.). To be
treated as capital, the funds must be surplus and must be exclusively for
capital expenditures: “it must be a firm final dedication, and not enough if ‘earmarked
primarily’” (page 5294 DTC, 11 C.T.C.).
[85]
The appellant pointed out that Ethicon
did not deal with a hedge and does not support the Minister’s restrictive
approach to the linkage principle. I agree that Ethicon does not suggest
that the linkage principle is limited in the manner suggested by the
respondent.
[86]
The appellant argued that nothing in the present
case suggests that the swaps were related to an underlying item that was on
income account (such as production or inventory costs, or sales revenues). Nor
is there any evidence showing that the intention was to make a profit in the
financial markets when entering into the swaps. As a matter of fact, GWL was
not permitted under either its credit facilities or its corporate policy to
speculate (GWL was only allowed to enter into hedging agreements for the
purpose of managing its risks in a manner consistent with the derivatives risk
management policy approved by the board of directors; see, for example: Exhibit
A-4, Tab 22, page 1230, par. 6.6 of a credit agreement with the Canadian
Imperial Bank of Commerce signed on July 25, 2001; GWL’s annual
reports for 2001, 2002 and 2003, Exhibit A‑1, Tab 1, page 51, Tab 2, page
125 and Tab 3, pages 223-224; and Minutes of the Board of Directors, Exhibit
A-9, Tab 2, pages 14-19).
[87]
The appellant added that GWL’s exclusive hedging
intention was reaffirmed in 2002 when Bestfoods West was sold for more than
anticipated, subsequent to which a corresponding number of swaps were
terminated to ensure that the amounts of the swaps did not exceed the net USD investments.
[88]
Further, added the appellant, GWL’s termination
of the swaps in 2003 was consistent with this intention because GWL only
intended to hedge the USD Operations while the associated currency risk
exceeded acceptable levels. After GWL concluded that the risk had declined in
2003 in that its debt to equity ratio had returned to the desired level, the
remaining swaps were no longer needed to protect the capital structure and were
terminated. The settlement of derivative contracts in advance of their maturity
date does not preclude those transactions from constituting a hedge (Echo
Bay, supra, at pages 730-31 F.C., par. 61 CarswellNat, and
appellant’s written submissions, par. 79, 84 and 98).
[89]
I agree with the appellant. My perception on the
whole is that, from a commercial perspective, GWL would not have entered into
the swaps in issue in the absence of the Bestfoods transaction. Before that
acquisition, GWL had entered into a few cross-currency swaps to hedge part of
its assets in the United States. Apart from that, it was not GWL’s policy to get
involved in derivatives or to speculate on currency fluctuations. I accept that
the intention in entering into the swaps was to hedge the investment in the USD
Operations, which exposed GWL to currency risk in that it had an impact on its
investments and its capital structure. GWL’s indirect investment in USD
Operations, just like its direct investment in its subsidiaries, was capital in
nature. I therefore find that the swaps were entered into to hedge a capital
investment.
[90]
Further, I also accept that in 2003, when the
appellant decided to terminate the swaps, there was no change of intention. The
appellant determined that its exposure risk associated with the investment in
USD Operations had decreased, in part because GWL had repaid some of its debt.
Both Mr. Mavrinac and Ms. Swartzman said that the debt to equity
ratio was expected to be back in line with GWL’s internal guideline of 1:1 by
the end of that year and that the balance sheet in the consolidated financial
statements was now strong enough for GWL to be able to absorb the risk exposure
due to currency fluctuations associated with an unhedged CTA. That being so,
the swaps were no longer required for the purposes that originally motivated
GWL to initiate them (Transcript, vol. 1, testimony of Mr. Mavrinac, pages
80‑81, and Ms. Swartzman, pages 228-232). The decision to terminate
the swaps early was related to a re-evaluation of the very risks which had caused
GWL to enter into the swaps in the first place. There is no evidence to suggest
that the termination was related to speculation or to a change in intention such
that the intent was now to profit from the derivatives market.
[91]
I conclude from the evidence given by the
appellant’s representatives, from the experts’ testimony and reports, and from
the case law, that financial derivatives, generally, are “contracts whose value
is based on the value of an underlying asset, reference rate, or index” (Placer
Dome, supra, par. 29). Such derivatives are used for the
purpose of mitigating a financial risk (hedging), as was the case, for example,
in Placer Dome and in Shell, supra, or for speculation, as
was the case in Salada Foods, supra.
[92]
It is true that accounting practices, by
themselves, do not establish rules of income tax law (Shell, par. 73)
It has also been determined that an accounting hedge may not be appropriate for
tax purposes in the absence of correlation between the hedge transaction and the
element of risk to be hedged (Saskferco, supra). However, I find,
as was suggested in Placer Dome, that the definition of hedging as
understood under well-established business principles, including GAAP, is
relevant, particularly in a situation, as in the present case, where the ITA is
silent and does not define what a hedge is for tax purposes (except, as
mentioned earlier, in section 20(3.1) of the ITA in the context of weak
currency loans; but that definition is not applicable here).
[93]
Professor Thornton in his expert report,
Exhibit A-12, at paragraphs 77‑88, concluded that the appellant satisfied
the GAAP requirements for hedge treatment: 1) it credibly designated the swaps
in advance, as a hedge in the consolidated financial statements, and 2) the swaps’
gains and losses were highly correlated with the CTA gains and losses and the
correlation remained effective throughout the entire time the hedge was in
place.
[94]
Professor Chlala, the respondent’s expert,
agreed that the appellant correctly recorded the swaps as hedges in its
consolidated financial statements (Professor Chlala’s expert report, Exhibit
R-1, page 4). However, Professor Chlala was of the opinion that it was the
appellant’s choice to designate the swaps as an accounting hedge instrument. In
his words, it could have reported the “gains or losses on such derivatives in
income in a similar manner as if the entity had been speculating” (pages 30-31
of his report). In fact, the gain on unwinding the swaps (at issue here) was
reported in operating costs on the income statement of GWL’s legal entity
financial statements (the non‑consolidated financial statements) for the
year 2003 (Exhibit R-1, Tab 1, and Transcript, vol. 3, pages 115-117). At the
same time, Professor Chlala stated that one set of financial statements
(consolidated or non-consolidated) was not more reliable than the other in
reporting the profits from closing out the swaps. He also noted that the legal
entity statements were inappropriate for investors (Transcript, vol. 3, pages
120-121). In his view, the “gains or losses on [the swaps should not] be
interpreted exclusively in light of their presentation in consolidated
financial statements in which hedge accounting rules were applied as permitted
under [GAAP]” (page 4 of his report). He had to admit in cross‑examination,
however, that he was not an expert in interpreting the tax treatment under the
ITA of gains or losses from unwinding swaps (Transcript, vol. 3, pages 140‑143).
[95]
I also note that though there was a choice to
implement hedge accounting, once the choice was made, the stringent GAAP rules
for hedge accounting had to be complied with. GWL made the decision before
entering into the swaps to implement hedge accounting and was therefore
required to adhere to the strict rules relating thereto (Thornton Report, par. 24-26
and 78-80). The respondent’s expert recognized this as well, stating that “[t]he
qualifying criteria for hedge accounting are rigorous and require a commitment
of time and resources” (Professor Chlala’s expert report, Exhibit R-1,
par. 56 and page 4).
[96]
I come to the conclusion that the appellant
entered into the swaps and rightly reported them as a hedge in its consolidated
financial statements for accounting and tax purposes. As noted by Professor
Thornton in his report, the consolidated financial statements are GWL’s
financial statements (Exhibit A-12, par. 49 and footnote 15). I am
satisfied that the appellant was not speculating, and that it was not its
policy to speculate through derivative instruments. It has been demonstrated
that the amount of the swaps matched as closely as possible the amount of the
net investment in self-sustaining US operations (Thornton Report, Exhibit A-12,
par. 19).
[97]
I also do not accept the respondent’s approach
which denies capital treatment to proceeds earned from a hedging contract if
there is no sale or proposed sale of the underlying item being hedged (see the
CRA’s published view on the matter reproduced in par. 110 of the
appellant’s submissions). I agree with the appellant that this view has no
legal basis and is a wrong interpretation of the case law. In Salada Foods,
there was no evidence linking the proceeds from the derivative to the capital
investment in the subsidiaries, and the derivative was clearly speculative. In Shell,
it was determined that hedge proceeds will be on capital account if the item
being hedged is a capital item. The Court did not lay down a rule that would support
the respondent’s restrictive approach. In Atlantic Sugar and Tip Top
Tailors, the derivatives were used to hedge what were clearly income
transactions. With regard to Placer Dome and Echo Bay, neither of these cases involved a capital versus income characterization. In Ethicon,
a secondary intention was established and a portion of the funds was clearly
used for income transactions.
[98]
In sum, the present case involves a situation
that has not previously been brought before the courts, at least that I am
aware of. The appellant made a commercial and business decision, after careful
consideration, to enter into the swaps in order to protect its consolidated
group equity. It knew better than anyone else the consequences of having its
net investment assets exposed to the risk of currency fluctuations. The swaps
are commercial derivatives designed expressly to circumvent that kind of risk.
As stated by Ms. Frost, the swaps were not speculative transactions. They were
designed for hedging in the financial market. Now when the risk vanished, there
was no need to keep the swaps. Here, GWL was satisfied that the swaps were no
longer necessary when the risk exposure of the net investment assets was
reduced significantly. They therefore decided to unwind the swaps. I have
concluded that the swaps were entered into to protect a capital investment, and
therefore they were linked to a capital asset. Absent unacceptable risk with
regard to those capital assets, the swaps had to be terminated since the reason
for their existence no longer applied, and the gain or loss from unwinding the
swaps should, in my view, be treated as being on capital account. The swaps were
not linked in any manner to any business income per se.
Adventure in the nature of trade
[99]
This alternative argument raised by the
respondent does not stand up.
[100] I have concluded that the appellant did not enter into the swaps for
speculative purposes. I have also concluded that the appellant’s initial
intention was not displaced by a subsequent speculative intention when the
decision was taken to unwind the swaps. The risk that existed when the swaps
were put in place had declined and there was no need to keep them anymore. To
make an analogy, an investor who buys shares for his portfolio may decide to
sell them if he is able to get a good price. This does not mean that he is
speculating. The same applies here. The fact that the appellant took the
opportunity to terminate the swaps when they were “in the money” does not
automatically transform the hedge transaction into speculation giving rise to
an adventure in the nature of trade, as long as there is a valid explanation
for ending the hedge.
[101] The appellant cited my decision in Belcourt Properties Inc. v.
The Queen, 2014 TCC 208, 2014 DTC 1182, which contains, at paragraph 30,
the following list of factors, set out in Happy Valley Farms Ltd. v.
The Queen, [1986] 2 C.T.C. 259, to be applied in determining whether a
transaction constitutes an adventure in the nature of trade,
Several
tests, many of them similar to those pronounced by the Court in the Taylor case, have been used by the courts in determining whether a gain is of an
income or capital nature. These include:
1. The
nature of the property sold. Although virtually any form of property may be
acquired to be dealt in, those forms of property, such as manufactured
articles, which are generally the subject of trading only are rarely the
subject of investment. Property which does not yield to its owner an income or
personal enjoyment simply by virtue of its ownership is more likely to have
been acquired for the purpose of sale than property that does.
2. The
length of period of ownership. Generally, property meant to be dealt in is
realized within a short time after acquisition. Nevertheless, there are many
exceptions to this general rule.
3. The
frequency or number of other similar transactions by the taxpayer. If the
same sort of property has been sold in succession over a period of years or
there are several sales at about the same date, a presumption arises that there
has been dealing in respect of the property.
4. Work
expended on or in connection with the property realized. If effort is put
into bringing the property into a more marketable condition during the
ownership of the taxpayer or if special efforts are made to find or attract
purchasers (such as the opening of an office or advertising) there is some
evidence of dealing in the property.
5. The
circumstances that were responsible for the sale of the property. There may
exist some explanation, such as a sudden emergency or an opportunity calling
for ready money, that will preclude a finding that the plan of dealing in the
property was what caused the original purchase.
6. Motive.
The motive of the taxpayer is never irrelevant in any of these cases. The
intention at the time of acquiring an asset as inferred from surrounding
circumstances and direct evidence is one of the most important elements in
determining whether a gain is of a capital or income nature.
[102] My decision in Belcourt, supra, cited Canada
Safeway Ltd. v. The Queen, 2008 FCA 24, 2008 DTC 6074, a case in which the Federal
Court of Appeal noted (at par. 43) that the most determinative factor is the
intention of the taxpayer at the time of acquiring the property. If that
intention reveals a profit‑making scheme, the transaction is an adventure
in the nature of trade.
[103] The Federal Court in Salada, supra, also provided
guidance on the issue. Referring to the Exchequer Court decision in M.N.R. v
James A. Taylor, 1956 CarswellNat 222, [1956] C.T.C. 189, a
number of negative and positive factors were outlined. The most relevant to
this appeal is one of the positive factors: “if a person deals with the
commodity purchased by him in the same way as a dealer in it would ordinarily
do such a dealing is a trading adventure” (Salada, supra, at 6174).
[104] In Ethicon Sutures, supra, the Federal Court said that
“where the transaction is a speculation made in the hope of profit, it will be
treated as an adventure in the nature of trade . . .” (page 5293 DTC, 10 C.T.C.).
[105] As described earlier in these reasons, GWL’s intention at the time
of entering into the swaps was to hedge the currency risk associated with an
increasing debt to equity ratio as a result of translating its US assets. Once the debt to equity ratio returned to acceptable levels, management
determined that the swaps were no longer necessary. Although there was a need
for cash in the business at the time the swaps were closed out, the evidence
demonstrates that the unhedged currency risk was acceptable to management given
the improved debt to equity ratio in 2003. In other words, in 2003 management felt
that volatility in an unhedged CTA would not put GWL offside of its internal
debt to equity guideline. GWL did not transform into a speculator in the
derivatives market, thereby violating its internal policies and credit
agreements, simply because the swaps were “in the money” when terminated.
[106] Further, GWL did not act as a dealer or trader in derivatives. Ms. Frost
concluded that GWL’s derivative transactions were inconsistent with speculating
in the currency market. She stated that if GWL had truly wanted to speculate on
the foreign exchange markets, “it would have likely used the more liquid spot
foreign exchange or options markets, which would be a much more efficient
speculative tool.” This is because swaps, especially long-term ones, are very
expensive and have high transaction costs (Riverside Report, par. 73(d)
and Transcript, vol. 2, pages 185-187). Further, management did not express a
view as to the future direction of the USD/CAD exchange rate. The analysis
focused on the risk of change and its impact on the balance sheet (Riverside
Report, par. 73(e) and Exhibit A-9, Tabs 3 and 6). Therefore the swaps by
their very nature were an inefficient means of profiting in the foreign
currency derivatives market, and GWL was not acting as a swap trader.
[107] As to length of ownership, GWL entered into the swaps for terms of
mostly 10 to 15 years, thereby incurring the transaction costs associated with
entering into long-term swaps. Although the swaps were terminated early, the
circumstances leading to the termination were linked to an evaluation of
business risk and not speculation on the exchange rate.
[108] To paraphrase Shell, supra, at paragraph 75, GWL
was not acting like a trader or dealer when entering into or terminating the
swaps. The swaps were used to hedge a risk in its business. In no sense was GWL
speculating in derivatives or engaged in an adventure in the nature of trade.
Alternative issue: if the swaps do not
constitute a hedge
[109] Because of my conclusion that the swaps were entered into as a hedge
in order to protect a capital investment and that therefore the gain derived
from terminating the swaps was on capital account, there is no need to address
the third issue raised by the parties, that is, whether the proceeds are to be
treated as being on capital or on income account regardless of whether the
swaps constitute a hedge.
Decision
[110] For the reasons set out above, the appeal is allowed with costs to
the appellant.
Signed at Ottawa, Canada, this 19th day of February 2015.
“Lucie Lamarre”
Email this Content