Specialty Manufacturing Ltd. v. R., 99 DTC 5222, [1999] 3 CTC 82 (FCA)

McDonald J.A.:

This is an appeal from a judgment of the Tax Court of Canada dismissing the appeal of Specialty Manufacturing Ltd. (the Appellant) from reassessments for its 1984 to 1987 taxation years. In each of those years, the Appellant sought to deduct amounts totalling $963,691 in respect of interest payments to two related U.S. corporations pursuant to paragraph 20(1)(c) of the Income Tax Act! [1] (the Act). The Minister of National Revenue (the Minister) denied $948, 661 of these deductions under subsection 18(4) of the Act.

Paragraph 20(1) of the Act reads as follows:

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

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

(i) borrowed money used for the purpose of earning income from a business or property...

20(1) Nonobstant les dispositions des alinéas 18(1 )a), b) et h), lors du calcul du revenu tiré par un contribuable d’une entreprise ou d’un bien pour une année d’imposition, peuvent être déduites celles des sommes suivantes qui se rap- portent entièrement à cette source de revenus ou la partie des sommes suivantes qu'il est raisonnablement être considérée comme s’y rapportant:

(c) Intérêts. -- une somme payée dans l’année ou payable pour l’année (suivant la méthode habituellement utilisée par le contribuable dans le calcul de son revenu) en exécution d’une obligation légale de verser des intérêts sur:

(i) de l’argent emprunté et utilisé en vue de tirer un revenu d’une entreprise ou d’un bien...

Subsection 18(4) reads as follows:

18. (4) Notwithstanding any other provision of this Act, in computing the income for a taxation year of a corporation resident in Canada from a business or property, no deduction shall be made in respect of that proportion of any amount otherwise deductible in computing its income for the year in respect of interest paid or payable by it on outstanding debts to specified non-residents that

(a) the amount, if any, by which

(i) the greatest amount that the corporation’s outstanding debts to specified non-residents was at any time in the year, exceeds

(ii) 3 times the aggregate of

(A) the retained earnings of the corporation at the commencement of the year, except to the extent that those earnings include retained earnings of any other corporation,

(B) the corporation’s contributed surplus at the commencement of the year, to the extent that it was contributed by a specified non-resident shareholder of the corporation, and

(C) the greater of the corporation’s paid-up capital at the commencement of the year and the corporation’s paid-up capital at the end of the year, excluding the paid-up capital in respect of shares of any class of the capital stock of the corporation owned by a person other than a specified non-resident shareholder of the corporation,

is of

(b) the amount determined under subparagraph (a)(i) in respect of the corporation for the year.

18. (4) Nonobstant les autres dispositions de la présente loi, dans le calcul du revenu d’une corporation résidant au Canada, tiré, pour une année d’imposition, d'une entreprise ou de biens, aucune déduction ne peut être faite relativement à la fraction des sommes déductibles par ailleurs dans le calcul de son revenu pour l’année au titre des intérêts payés ou payables par cette corporation sur les dettes de la corporation qui nont pas encore été payées à des non-résidents déterminés, représentée par le rapport entre

(a) la fraction, si fraction il y a,

(i) du montant le plus élevé auquel s’élevaient les dettes de la corporation, qui nont pas encore été payées à des non-résidents déterminés, à une date quelconque de lannée,

(ii) trois fois le total des montants suivants:

(A) les bénéfices non répartis de la corporation au début de l’année, sauf dans la mesure où ces bénéfices comprennent des bénéfices non distribués d’une autre corporation,

(B) le surplus d’apport de la corporation au début de l’année, dans la mesure où il a été fourni par un actionnaire non résidant déterminé de la corporation, et

(C) le plus élevé du capital versé de la corporation au début de l’année ou de son capital versé à la fin de l’année, à l’exclusion du capital versé a l?égard des actions d’une catégorie quelconque du capital- actions de la corporation appartenant à une personne autre qu?un actionnaire non résidant déterminé de la corporation;

et

(b) la somme déterminée en vertu du sous-alinéa (a)(i) relativement à la société pour l’année.

Outstanding debts to specified non-residents, Specified non-resident and specified non-resident shareholder are defined in subsection 18(5). At the relevant times, these definitions read as follows:

18(5)(a) outstanding debts to specified non-residents of a corporation at any particular time in a taxation year means

(i) the aggregate of all amounts each of which is an amount outstanding at that time as or on account of a debt or other obligation to pay an amount

(A) that was payable by the corporation to a person who was, at any time in the year,

(I) a specified non-resident shareholder of the corporation, or

(II) a non-resident person, or a non-resident- owned investment corporation, who was not dealing at arm ’s length with a specified Shareholder of the corporation, and

(B) on which any amount in respect of interest paid or payable by the corporation is or would be, but for subsection (4), deductible in computing the corporation’s income for the year,...

(b) specified non-resident shareholder of a corporation at any time means a specified shareholder of the corporation who was at that time a non-resident person or a non-resident-owned investment corporation, and

(c) specified shareholder of a corporation at any time means a shareholder who at that time, either alone or together with persons with whom that he was not dealing at arm?s length, owned 25% or more of the issued shares of any class of the capital stock of the corporation.

18(5)(a) dettes de la corporation qui nont pas encore été payées à des non-résidents déterminés, à une date donnée dune année dimposition, désigne

(i) le total de toutes les sommes dont chacune représente une somme due à cette date, a titre ou au titre d’une dette ou autre obligation de verser un montant,

(A) qui était payable par la corporation à une personne qui était, à une date quelconque de l’année,

(I) un actionnaire non résidant déterminé de la corporation, Ou

(II) une personne non-résidante ou une corporation de placement appartenant à des non-résidents, qui avait un lien de dépendance avec un actionnaire déterminé de la corporation,

(B) au titre de laquelle toute somme relative à des intérêts payés ou payables par la corporation est déductible ou serait déductible, n?eût été le paragraphe (4), dans le calcul du revenu de la corporation pour l’année,

à l’exclusion,...

(b) actionnaire non-résidant déterminé d’une corporation à une date quelconque désigne un actionnaire déterminé de la corporation qui était à cette date une personne non résidante ou une corporation de placements appartenant à des non- résidents; et

(c) actionnaire déterminé d’une corporation à une date quelconque désigne un actionnaire de la corporation qui seul, ou avec d autres personnes avec lesquelles il avait un lien de dépendance, était à cette date propriétaire d’au moins 25% des actions émises d’une catégorie quelconque du capital-actions de la corporation.

[emphasis added]

Also of significance is section 251 of the Act. The relevant portions of this section read as follows:

251(1) For the purposes of this Act,

(a) related persons shall be deemed not to deal with each other at arm’s length; and

(b) it is a question of fact whether persons not related to each other were at a particular time dealing with each other at arm’s length.

(2) For the purpose of this Act, “related persons”, or persons related to each other, are

(b) a corporation and

(i) a person who controls the corporation, if it is controlled by one person,

(ii) a person who is a member of a related group that controls the corporation, or

(iii) any person related to a person described in subparagraph (i) or (ii); and

(c) any two corporations

(i) if they are controlled by the same person or group of persons…

(iii) if one of the corporations is controlled by one person and that person is related to any member of a related group that controls the other corporation,...

251(1) Aux fins de la présente loi:

(a) des personnes liées sont réputées avoir entre elles un lien de dépendance;

(b) la question de savoir si des personnes non liées entre elles n’avaient aucun lien de dépendance à un moment donné est une question de fait.

(2) Aux fins de la présente loi, sont des “personnes liées” ou des personnes liées entre elles, sont

(b) une corporation et:

(i) une personne qui contrôle la corporation si cette dernière est contrôlée par une personne,

(11) une personne qui est membre d’un groupe lié qui contrôle la corporation,

(iii) toute personne liée à une personne visée au sous-alinéa (i) ou (11);

(c) deux corporations quelconques

(i) si elles sont contrôlées par la même personne ou le même groupe de personnes,...

(iii) si l?une des corporations est contrôlée par une personne et si cette personne est liée à un membre d?un groupe lié qui con- tôle l?autre corporation.

[emphasis added]

It is clear that where interest is payable by a Canadian corporation to a non-resident shareholder holding or controlling more than a 25% interest in the company, subsection 18(4) operates to limit any deduction of interest pursuant to paragraph 20(1)(c) of the Act if the debt to equity ratio of the taxpayer corporation exceeds 3 to I. The Appellant argues that as the Minister has admitted that the arrangements in this case are structured as if they were between arms length parties, the provisions of the Canada-United States of America Tax Convention? [2] (the 1942 Treaty) and the Canada- United States Tax Convention (1980)$ [3] (the 1980 Treaty) operate to preclude the application of subsection 18(4).

Specifically, the Appellant argues that, in respect of his 1984 and 1985 taxation years, paragraph 1 of Article IV of the 1942 Treaty supercedes the application of subsection 18(4) of the Act. [4] This article reads:

(a) When a United States enterprise, by reason of its participation in the management or capital of a Canadian enterprise, makes or imposes on the latter, in their commercial or financial relations, conditions different from those which would be made with an independent enterprise, any profits which should normally have appeared in the balance sheet of the Canadian enterprise but which have been, in this matter, diverted to the United States enterprise, may be incorporated in the taxable profits of the Canadian enterprise, subject to applicable measures of appeal.

(b) In order to effect the inclusion of such profits in the taxable profits of the Canadian enterprise, the competent authority of Canada may, when necessary, rectify the accounts of the Canadian enterprise, notably to correct errors and omissions and to re-establish the prices or remuneration entered in the books at values which would prevail between independent persons dealing at arm’s length. To facilitate such rectification the competent authorities of the contracting States may consult together with a view to such determination of profits of the Canadian enterprise as may appear fair and reasonable.

[emphasis added]

Similarly, for its 1986 and 1987 taxation years, the Appellant argues that paragraph 1 of Article IX of the 1980 Treaty prevents the Minister from applying subsection 18(4). This provision reads:

I. Where a person in a Contracting State and a person in the other Contracting State are related and where the arrangements between them differ from those which would be made between unrelated persons, each State may adjust the amount of the income, loss or tax payable to reflect the income, deductions, credits or allowances which would, but for those arrangements, have been taken into account in computing such income, loss or tax.

[emphasis added]

Facts

The Appellant is a corporation in the business of distributing novelties and souvenirs at expositions, carnivals and fairs. The Appellant was incorporated in British Columbia and at all relevant times was resident in Canada for purposes of the Act. Up to April 1, 1987, Mr. and Mrs. Ben Mayers (the Mayers), two U.S. residents, owned all the shares of the Appellant. On April 1, 1987 the Mayers transferred their shares of the Appellant to Ace Novelty Co., Inc. (Ace), a U.S. corporation which manufactures, sells and imports novelties and souvenirs in Washington State. At all relevant times, the Mayers were the sole shareholders of Ace. Mr. Mayers was also the sole shareholder of World’s Fair Souvenirs, Inc. (Worlds), another novelty and souvenir company based in Washington State.

At all relevant times, the Mayers, Ace and Worlds were related persons for the purposes of the Act. Furthermore, pursuant to section 251, they are deemed not to deal with one another at arms length. Until April 1, 1987, the Mayers were specified non-resident shareholders of the Appellant for the purposes of subsection 18(4) by virtue of the fact that they owned or controlled 100% of the Appellants shares. After April 1, 1987, Ace became a specified non-resident shareholder of the Appellant.

It is clear that any amounts that the Appellant borrowed from Ace and Worlds would be outstanding debts to specified non-residents for the purposes of subsection 18(4). At all relevant times, these amounts were payable to either: (1) non-resident persons, i.e. Ace and Worlds who were not dealing at arms length with specified non-resident shareholders of the Appellant; or (2) specified non-resident shareholders directly (i.e. Ace after April 1, 1987).

During 1983 and 1984 Ace and Worlds negotiated a contract, on behalf of the Appellant, with the Expo 86 Corporation to operate the novelty and souvenir concessions during the World Exposition (Expo 86) held in Vancouver, B.C. from May 2 to October 13, 1986. On June 6, 1984, the Appellant, Ace and World’s entered into an agreement that Ace and World’s would provide management, administrative and financial services to the Appellant in respect of the Expo 86 contract.° [5]

During its 1984-1987 taxation years, the Appellant borrowed money (the Debts) from Ace and Worlds in order to finance its operations and carry out the Expo 86 contract. In each of the relevant taxation years, the Appellants capital structure was as follows:

To fund the Debts, Ace and Worlds borrowed money from Seafirst Bank in Washington State (Seafirst).

In its 1984-1987 taxation years the Appellant paid or incurred a liability for interest to Ace and World’s in respect of the Debts as follows:

The interest rate paid by the Appellant was equal to the interest rate paid by Ace and World’s to Seafirst on the money they had borrowed to fund the Debts.

In computing its income for the 1984-1987 taxation years, the Appellant deducted the interest paid or payable to Ace and World’s in each year pursuant to paragraph 20(1)(c) of the Act. Pursuant to subsection 18(4) of the Act, the Minister reassessed the Appellant in the following manner:

The Appellant objected to the reassessments for each year on the basis that the Ministers disallowance of the interest deductions was not permitted under the terms of the Canada-U.S. Tax Treaty in force in each of the relevant taxation years. Specifically, the Appellant argued: (1) that Article IV of the 1942 Treaty precluded the application of subsection 18(4) to its 1984 and 1985 taxation years; and (2) that Article IX of the 1980 Treaty applied to its 1986 and 1987 taxation years. The reassessments were subsequently confirmed by the Minister and the Appellant appealed to the Tax Court of Canada. The Tax Court Judge dismissed the Appellants appeal on the grounds that the neither the 1942 Treaty nor the 1980 Treaty limited the application of subsection 18(4). [7]

Analysis

As noted, subsection 18(4) provides that where more than 25% of the shares of a Canadian corporate taxpayer are owned by a non-resident, the deduction of interest by the taxpayer pursuant to paragraph 20(1)(c) for interest paid on loans obtained from the non-resident shareholder is limited to the extent that the taxpayers debt level does not exceed three times its equity. If the corporations debt to equity ratio exceeds 3:1, the interest on the amount of the loans in excess of this ratio is treated as income and the interest deduction is disallowed.

The motivation for the imposition of the 3:1 debt/equity rule (or thin capitalization rule) is to prevent the non-resident shareholders from capitalizing a Canadian corporation with excessive debt, thereby deducting the interest on the excessive debt in computing taxable income, that is to say, withdrawing income from the Canadian corporation as interest without pay- ing Canadian income tax thereon. As stated by Madame Justice Reed in Uddeholm Limited: [8]

There is no dispute as to the purpose of subsections 18(4) to (8) of the Income Tax Act, ...Those provisions are directed at preventing non-residents of Canada who own significant shareholdings (generally over 25%), in Canadian resident corporations, from withdrawing the profits of the Canadian corporation in the form of interest payments rather than in the form of dividends paid on the shares of the corporation. 1 quote from page 4423 of the CCH Canadian Tax Service:

Both interest and dividends paid to non-residents are subject to withholding tax under Part XIII but since interest is, but for the limitation in subsection 18(4), deductible in computing the income of the resident corporation subject to Canadian tax, it would clearly be to a non-resident’s advantage to finance the operation of a Canadian resident corporation through interest bearing debt rather than through share capital, which would lead to the establishment of thinly capitalized corporations.

It is uncontested that in the absence of the U.S.-Canada Tax Treaties, subsection 18(4) would operate to disallow $948,661 of the interest deductions claimed by the Appellant. The Appellant contends that Article IV of the 1942 Treaty and Article IX of the 1980 Treaty operate to restrict the Ministers authority under subsection 18(4).

The relevant 1942 and 1980 treaty provisions clearly indicate that where two or more related parties engage in transactions which do not reflect arms length arrangements, the tax consequences of the transactions may be adjusted by domestic taxing authorities. In essence, the Appellants argument is that the converse must also be true. In other words, where two or more related parties engage in a transaction on terms which reflect an arms length relationship, domestic taxing authorities are precluded from adjusting the income, deductions or other tax consequences of the transaction. Given the facts of this case, I find it unnecessary to deal with the Appellants arguments regarding the application of the Tax Treaties.

The fundamental basis for the Appellants argument is an apparent admission by the Minister during discovery that the arrangements between the Appellant, Ace and Worlds were the same as if they were arms length trans- actions. The Appellant relies upon the following answers given on discovery by Myrna Chen, a senior appeals officer with Revenue Canada: [9]

Q: Now, I take it youd agree with me that the interest rate paid by Specialty to Ace and Worlds Fair for the 1984 through to the 1987 taxation years on the debts shown in paragraph 3.28 was an arms-length rate of interest; is that correct

A: Yes. [Counsel for the Crown]: Market rate, arms length.

Q: Well particularly, was it an arms-length rate of interest

A: Yes.

Q: ...Would it be correct to say that in analyzing article 9, you assumed that the structure of capital was the same as it would have been in an arms length transaction

A: Correct.

The Appellant also relies on the following passages from the Statement of Agreed Facts in this regard: [10]

22. The Debts [owed by the Appellant to Ace and Worlds] were true debts.

25. The interest rate paid by the Appellant to Ace and Worlds in respect of the Debts was an arms length interest rate, equal to the rate Ace and Worlds paid to Seafirst on the money borrowed by them to fund the Debts.

There is no indication that the interest rate paid by the Appellant was not an arms length interest rate, nor is there any issue that the Debts were true debts. The only issue is whether the capital structure of the Appellant is the same as or different than an arms length capital structure. It obviously is not the same. The Appellant had virtually no equity capital and was financed almost exclusively by loans from Ace and Worlds. Indeed, Ms. Chen noted the emphasis on debt financing in the Appellants capital structure:

Q: And you say, It appears that the arrangement is same as unrelated persons and then in bold letter, you say, ™ EXCEPT FOR THE STRUCTURE OF CAPITAL. I therefore conclude that the arrangement is not the same as unrelated persons. Could you explain for me, please, what you meant by the words except for the structure of capital

A: When I looked at this, I was reviewing the terms of the loan being the interest rate, essentially the interest rate, that was charged between corporations, and I said that it was dealt with as though they were arms-length. When I put this in there, I was thinking about the possibility that an arms length party might not loan as much as what Sea-First -- or sorry, as what Ace and World would have.

She continued stating:

Q: All right.

A: So it kind of throws you.

Q: No, go on.

A: So 1 was strictly looking at what the terms of the loans were, and I said, okay, it is what an arms length party would have entered into so therefore well accept it.

Q: But particularly on the words except for the structure of capital, do I now understand you to say that those words did not enter into your assumptions at all in re-assessing Specialty

A: For the purposes of analyzing article 9, yes.

The most that can be said about the admissions made by Ms. Chen is that they are ambiguous. More likely they do not reflect the facts fully. The Court will not ignore the obvious. Clearly, a debt to equity ratio of over $10,000,000 debt to $100 equity does not resemble an arms length situation. Obviously, with virtually no equity capital, no arms length lender would have issued loans to the Appellant in the substantial amounts at issue in this case.

On the facts before the Court, the loan transactions giving rise to the interest claimed by the Appellant are clearly non-arms length transactions. Accordingly, the Minister was entitled to use subsection 18(4) of the Act to restrict the deductions claimed under paragraph 20(1 )(c) of the Act. Indeed, such a result is authorized by both Article IV of the 1942 Treaty and Article IX of the 1980 Treaty.

It must be noted that the Tax Court Judge did not address the issue of whether the loan transactions were the same as those between arms length parties. He adopted facts from the Statement of Agreed Facts put forward by the parties, but did not address the admissions of Ms. Chen. Accordingly, he did not make any express factual findings which are in conflict with my conclusion that these were not the same as arms length transactions.

Disposition

I would dismiss the appeal with costs.

Appeal dismissed.