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Citation: 2004TCC689
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Date: 20041015
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Docket: 2002-467(IT)G
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BETWEEN:
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EASTERN SUCCESS CO. LTD., IN ITS CAPACITY
AS TRUSTEE OF THE EASTER LAW TRUST,
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Appellant,
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and
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HER MAJESTY THE QUEEN,
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Respondent.
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REASONS FOR JUDGMENT
MoganJ.
[1] Part XIII of the Income Tax
Act (the "Act") imposes a tax on
non-resident persons with respect to certain kinds of income
(e.g. interest, rent, royalty, management fee, etc.) which they
receive from persons resident in Canada. The operative words of
subsection 212(1) state:
212(1) Every non-resident person shall pay an income tax
of 25% on every amount that a person resident in Canada pays or
credits, or is deemed by Part I to pay or credit, to the
non-resident person as, on account or in lieu of payment of, or
in satisfaction of,
(a) ...
There follows a list of about 20 different kinds of income
which is subject to the Part XIII tax. The tax is collected by
requiring the person resident in Canada who pays the income (to
the non-resident) to withhold and remit:
215(1) When a person pays, credits or provides, or is
deemed to have paid, credited or provided, an amount on which an
income tax is payable under this Part, ... the person shall,
notwithstanding any agreement or law to the contrary, deduct or
withhold from it the amount of the tax and forthwith remit that
amount to the Receiver General on behalf of the non-resident
person on account of the tax and shall submit with the remittance
a statement in prescribed form.
[2] On March 1, 1997, the Appellant
paid an amount of interest totalling $3,430,899 to a corporation
not resident in Canada. The Minister of National Revenue
concluded that a portion ($2,421,059) of that amount of interest
was subject to Part XIII tax, and assessed a 25% tax of
$605,264.75 with respect to that portion. The assessment was
issued to the Appellant because of its failure to withhold and
remit the tax under subsection 215(1). The Appellant has appealed
from that assessment. The only issue is whether the Appellant (in
all the circumstances of this case) was required to withhold and
remit the 25% tax of $605,264.75 assessed under Part XIII.
[3] At the commencement of the
hearing, counsel for both parties filed an Agreed Statement of
Facts stating that they would not be calling any witnesses
because all of the relevant facts were contained either in the
agreement or in a Joint Book of Documents. Accordingly, the Joint
Book of Documents (containing Tabs 1 to 11) was entered as
Exhibit 1; and the Agreed Statement of Facts ("ASF")
was entered as Exhibit 2. Because the ASF is brief, I will set it
out in full.
Agreed Statement of Facts
For the purposes of this appeal, the parties agree to the
facts in this Statement of Facts. The parties agree that other
evidence may be introduced by either party, to the extent that
such evidence is not inconsistent with the following facts:
1. For the
purposes of this Statement of Facts, Eastern Success Company Ltd.
will be referred as the "Trustee", The Easter Law Trust
will be referred to as the "Trust", and the Trustee and
Trust will be collectively referred to as the Appellant.
2. At all
material times, the Trustee was trustee of the Trust and acted on
behalf of the Trust.
3. At all
material times, the Trustee was a corporation resident in Hong
Kong and was a non-resident of Canada.
4. The Trust
is a non-resident of Canada whose sole beneficiary is the Society
for the Promotion of Hospice Limited.
5. Since
December 5, 1988, the Appellant has carried on the business of
real estate development in Canada in a joint venture to develop
and sell residential real estate in Vancouver, British Columbia
(the "Real Estate Business"). The joint venture was a
condominium project called "Yacht Harbour Pointe" (the
"Joint Venture").
6. Since at
least June 30, 1993, the Appellant held a 63.25% interest in the
Joint Venture with two other joint venturers, HCH Land Co. Ltd.
and Edivin Limited.
7. On January
30, 1992, and in the course of this Joint Venture, the Appellant
entered into a written loan agreement with Sparkling Tiara
Limited (the "Lender") to borrow money (the
"Agreement").
8. The Lender
is a company incorporated in the British Virgin Islands and is a
non-resident of Canada.
9. The
Agreement contained a maximum borrowing limit called a "loan
facility". The loan facility under the Agreement was
$6,000,000 Canadian.
10. Under the Agreement,
the Appellant was permitted to draw down the loan facility within
one month from the date of the Agreement and interest would
accrue on the amount drawn (the "Loan") at the rate of
12% "for the period from the Drawdown Date to the completion
date of construction of the condominium project and 6% thereafter
until the [L]oan is fully repaid".
11. The Agreement was
amended by letter dated February 15, 1992 (the "Amendment
Letter"), to increase the amount of the loan facility to
$7,000,000 Canadian and to change the due date for the Loan to
two years from the completion date of construction.
12. Construction was
completed in March 1995.
13. The interest which
related to the period of construction of the real estate
development and was part of the Appellant's costs of goods
sold was $1,127,941 in the Appellant's 1995 taxation year,
$937,508 in its 1996 taxation year and $355,610 in its 1997
taxation year.
14. From 1988 to the
completion of construction in March 1995, interest in the amount
of $2,850,637 accrued on the Loan (the "Construction
Interest").
15. In filing its return
of income for 1995, 1996, and 1997 under Part I of the Income
Tax Act and in computing its taxable income earned in Canada
in respect of the Real Estate Business, the Appellant computed
its profit from the Real Estate Business on the basis that no
amount was deductible in respect of the interest, as it related
to the period of construction under subsection 18(3.1) of
the Act.
16. During the period of
construction, the Construction Interest was included in its cost
of inventory by the Appellant for the purpose of its balance
sheet and computing its profit, as well as pursuant to subsection
18(3.1) of the Act.
17. On March 1, 1997, the
Appellant paid interest totalling $3,430,899 to the Lender. This
amount was comprised of the Construction Interest as well as
post-construction interest.
18. Of the Construction
Interest, $2,421,059 was ultimately included by the Appellant in
1995, 1996, and 1997 as part of the cost of goods sold in
computing its profit when some of the condominium units were
sold.
19. This portion of the
Construction Interest was paid or credited to the Lender on March
1, 1997.
20. By Notice of
Assessment dated August 15, 2000, the Minister of National
Revenue assessed the Appellant $605,264.75 tax (being 25% of
$2,421,059) and $204,533.42 interest under Part XIII of the
Act in respect of interest paid or credited by the
Appellant to the Lender and for the Appellant's failure to
withhold tax under Part XIII in respect of these payments.
21. The Minister proceeded
on the assumption that the interest was deductible to the
Appellant in computing its income and the amount was accordingly
subject to tax under Part XIII by virtue of the provisions of
subsection 212(13.2) of the Act.
22. By Notice of Objection
dated October 31, 2000, the Appellant objected to the Notice of
Assessment.
23. By Notice of
Confirmation dated November 8, 2001, the Minister of National
Revenue confirmed the Notice of Assessment.
[4] The ASF refers to two provisions
of the Act which are important in the determination of
this appeal. Subsection 18(3.1) requires the capitalization of
certain outlays or expenses which would otherwise be deductible
in the year they are incurred.
18(3.1) Notwithstanding any other provision of this
Act, in computing a taxpayer's income for a taxation
year,
(a) no
deduction shall be made in respect of any outlay or expense made
or incurred by the taxpayer ... that can reasonably be
regarded as a cost attributable to the period of the
construction, renovation or alteration of a building by or on
behalf of the taxpayer, ... and relating to the
construction, renovation or alteration, or a cost attributable to
that period and relating to the ownership during that period of
land
(i) that is
subjacent to the building, or
(ii) ...
(b) the
amount of such an outlay or expense shall, to the extent that it
would otherwise be deductible in computing the taxpayer's
income for the year, be included in computing the cost or capital
cost, as the case may be, of the building to the taxpayer,
...
Subsection 212(13.2) is unusual because, in certain
circumstances, it deems a non-resident person to be a person
resident in Canada for the purposes of Part XIII. The
Minister relies on subsection 212(13.2) to make the Appellant
liable under Part XIII.
212(13.2) For the purposes of this Part, where in a taxation
year
(a) a
non-resident person whose business was carried on principally in
Canada, or
(b)
...
pays or credits an amount ... to another non-resident
person, the first-mentioned non-resident person shall be
deemed, in respect of the portion of that amount that was
deductible in computing that person's taxable income earned
in Canada for any taxation year, to be a person resident in
Canada.
[5] Having regard to the conditions
which must be satisfied for the application of subsection
212(13.2), the parties agree that the Appellant was a
non-resident person at all relevant times (ASF, paragraphs 1, 2,
3 and 4). Also, in argument, the Appellant's counsel conceded
that the Appellant's business was carried on principally in
Canada. And finally, both counsel agreed that the following
words, taken from the latter part of subsection 212(13.2), are
the important words to construe when deciding this appeal:
... in respect of the portion of that amount that was
deductible in computing that person's taxable income earned
in Canada for any taxation year, ...
Section 115 of the Act contains specific rules to
determine the taxable income earned in Canada for a taxation year
by a non-resident person.
[6] The ASF speaks for itself but, at
the risk of error, I find it helpful to restate certain facts in
a different order and to link them more directly with the
relevant provisions of the Act. References to particular
paragraphs will refer to the ASF and not to these Reasons for
Judgment:
(i) The loan agreement with
Sparkling Tiara is dated January 30, 1992, and construction of
the Yacht Harbour Pointe condominium project was completed in
March 1995. Paragraphs 5, 7 and 12.
(ii) Under that loan agreement,
interest in the amount of $2,850,637 was accrued to the
completion of construction in March 1995. Paragraphs 10 and
14.
(iii) The Appellant paid interest in
the total amount of $3,430,899 on March 1, 1997 but, of that
amount, only $2,850,637 had been capitalized as part of the cost
of the condominium project under subsection 18(3.1) of the
Act; and no part of the $2,850,637 was deducted as
interest in computing the Appellant's taxable income earned
in Canada during the period of construction. Paragraphs 14, 15,
16 and 17.
(iv) The Appellant started selling
units in the condominium project in 1995, and continued selling
in 1996 and 1997. The parties agree that the amount $2,421,059 is
the pro rata portion of the capitalized Construction Interest
($2,850,637) which related to the units actually sold in the
years 1995, 1996 and 1997. Paragraphs 13, 14 and 18.
(v) The basic question in this case is
whether the amount $2,421,059 was "deductible in
computing" the Appellant's "taxable income earned
in Canada for any taxation year" within the meaning of
subsection 212(13.2) of the Act. Paragraphs 18, 19, 20 and
21.
Analysis
[7] I refer to the Construction
Interest ($2,850,637) as having been "capitalized"
under paragraph 18(3.1)(b) because it was included in
computing the cost of the building which, in the circumstances of
this appeal, was a condominium project. When an amount of
interest (otherwise deductible in computing income under
paragraph 20(1)(c) of the Act) is so capitalized,
it loses its character as "interest" and becomes merged
in the overall cost of the building like the cost of the concrete
foundation, brick siding, windows, roof and heating plant. Each
of these component items loses its character as concrete, brick,
windows, etc. and the aggregate cost of all such items becomes a
cost of inventory when the building is a condominium project with
units for sale.
[8] Relating the agreed facts to the
terms of subsection 212(13.2), the Appellant as a non-resident
person paid an amount ($3,430,899) to another non-resident
person in 1997. As between the Appellant (payor) and the other
non-resident person (payee), the entire amount was interest. See
paragraph 17. Was a portion ($2,421,059) of that entire amount
deductible in computing the Appellant's taxable income earned
in Canada for any taxation year? As a practical matter, and
without regard to any decided cases, I would answer
"no" for two reasons. First, the amount $2,421,059 may
have had the character of interest as between the payor and the
payee because it was part of a larger amount ($3,430,899) which
they both regarded as interest. But for purposes of the
Act, the smaller amount of $2,421,059 had lost its
character as "interest" because it was part of a larger
amount ($2,850,637) which was capitalized as part of the cost of
the condominium units and, therefore, part of the cost of the
Appellant's inventory.
[9] And second, under Part I of the
Act, there is a significant difference between computing
income (Division B, sections 3 to 108) and computing taxable
income (Division C, sections 109 to 114.2). There is a separate
provision (Division D, sections 115 to 116) for determining the
taxable income earned in Canada by non-resident persons. In
my view, the following parts of subsection 115(1) are
relevant:
115(1) For the purposes of this Act, the taxable
income earned in Canada for a taxation year of a person who at no
time in the year is resident in Canada is the amount, if any, by
which the amount that would be the non-resident
person's income for the year under section 3 if
(a) the
non-resident person had no income other than
(i)
...
(ii) incomes from
businesses carried on by the non-resident person in Canada
...
(b)
...
exceeds the total of
(d) the
deductions permitted by subsection 111(1) and, to the extent that
they relate to amounts included in computing the amount
determined under any of paragraphs (a) to (c), the
deductions permitted by any of paragraphs 110(1)(d) to
(d.2) and (f) and subsection 110.1(1),
(e)
...
I assume that the Appellant had only business income in Canada
from the joint venture condominium project. The opening words of
subsection 115(1) incorporate by reference "income for the
year under section 3" which is the basic section of Part I.
Section 3 is totally inclusive capturing income from all sources
including business. The computation of income from business is
determined primarily by subdivision b (sections 9 to 37.3) which
would include, of course, sections 9, 12, 18 and 20. Because the
amount ($2,421,059) which I refer to as "capitalized"
is not deductible under paragraph 20(1)(c) (see paragraph
18(3.1)(a)), that amount cannot be regarded as
"deductible in computing the Appellant's taxable income
earned in Canada" for any year.
[10] The case law supports the Appellant. In
Oryx Realty Corp. v. M.N.R., 74 DTC 6352, the Federal
Court of Appeal considered subsection 12(3) of the 1952
Act as it applied to the 1960 taxation year.
12(3) In computing a taxpayer's income
for a taxation year, no deduction shall be made in respect of an
otherwise deductible outlay or expense payable by the taxpayer to
a person with whom he was not dealing at arm's length if the
amount thereof has not been paid before the day one year after
the end of the taxation year; but, if an amount that was not
deductible in computing the income of one taxation year by virtue
of this subsection was subsequently paid, it may be deducted in
computing the taxpayer's income for the taxation year in
which it was paid.
[11] In 1959, Oryx had purchased from a
non-arm's length vendor a parcel of land for $174,000 paying
only $1,000 in cash with the balance payable over 10 years.
On July 21, 1960, after some shares of Oryx were sold, Oryx was
at arm's length with the vendor. Later on July 21, Oryx sold
the parcel of land for $373,000. Oryx claimed that the profit on
the resale was $199,000 ($373,000 less $174,000). The Minister of
National Revenue assessed tax against Oryx on the basis that the
profit on the sale was $354,000 being the proceeds of sale
($373,000) less the amount ($18,500) which had been paid by Oryx
toward the cost of the land as at the time of sale. The Minister
of National Revenue was relying on subsection 12(3) as set out
above.
[12] Before the Federal Court of Appeal,
Oryx argued that subsection 12(3) did not apply for two reasons:
(i) the purchase price was not an "otherwise deductible
outlay or expense"; and (ii) the purchase price was not
payable to a non-arm's length vendor. The Federal Court of
Appeal was unanimous in accepting the Oryx second argument
that (a) the purchase price did not become deductible until the
land was sold in July 1960; and (b) at that time, the purchase
price was no longer payable to a non-arm's length vendor.
Although it was not necessary to consider the Oryx first
argument, a majority of the Court (Jackett C.J. and Thurlow J.A.)
expressed an opinion. The following passage from Jackett C.J. is
important.
What we are concerned with here is "gross profit".
"The law is clear ... that for income tax purposes gross
profit, in the case of a business which consists of acquiring
property and reselling it, is the excess of price over cost
..." (See MNR v. Irwin, [1964] S.C.R. 662, 64 DTC
5227) per Abbott J., delivering the judgment of the Court, at
pages 664-65). Gross trading profit for a taxation year may be
obtained by adding together the profits of the various
transactions completed in the year or by adding together the
prices at which sales were effected in the year and deducting the
aggregate of the costs of the various things sold. Either of such
methods would be suitable for a business consisting of relatively
few transactions. In the ordinary trading business, however, the
practice, which has hardened into a rule of law, is that profit
for a year must be computed by deducting from the aggregate
"proceeds" of all sales the "cost of sales"
computed by adding a value placed on inventory at the beginning
of the year to the cost of acquisitions in the year and deducting
a value placed on inventory at the end of the year.
In considering what application section 12(3) has, there can
be no doubt that "gross profit" must be computed before
income can be determined and that, at least in the second method
of computing "gross profit" indicated above, the price
for which the property was bought is "deductible" in
its computation. "If, on the other hand, the computation of
"income" for a taxation year is thought of as
commencing with "gross profit" then the
"cost" of the property bought is not an amount that is
"deductible" in its computation. When, moreover, one
thinks of applying section 12(3) to a trader whose transactions
are so numerous or of such a character as to dictate the use of
the proceeds of sales less cost of sales formula, then, in the
"computation" of the "taxpayer's income for a
taxation year" there is no deduction, at least as such, of
the cost of the goods that were sold in the year. Presumably,
however, section 12(3) is to have the same effect in
relation to the computation of a taxpayer's income for a year
regardless of the method that has to be used to compute
"gross profit". With considerable hesitation, I have
come to the conclusion that section 12(3) should be interpreted,
in the case of business income, as referring to the computation
of "income" or profit" for a year from the
"gross profit" for the year; and was not, therefore.
applicable in the circumstances of this case. In reaching that
conclusion, I am conscious that, in other contexts, for more than
a century the general statements in the leading cases concerning
business profits have treated the computation of profit as
including the computation of gross profit. What has brought me to
the opposite conclusion in the interpretation of section 12(3) is
the necessity of giving such meaning to that subsection as will
operate with consistency in the different circumstances to be
encountered in the normal course of events.
[13] When an identical transaction was taken
to the Supreme Court of Canada in M.N.R. v. Shofar Investments
Corporation, 79 DTC 5347, Martland J. wrote the judgment for
the Court in favour of the taxpayer and, after quoting the above
passage from Jackett C.J. in the Federal Court of Appeal, stated
his (Martland J.'s) agreement with Jackett C.J.'s
conclusion.
[14] In my opinion, the decisions of the
Federal Court of Appeal in Oryx and the Supreme Court of
Canada in Shofar, are conclusive in support of the
Appellant's position. In particular, I rely on the following
statements which are extracted from the Oryx passage
quoted above:
... If, on the other hand, the computation of
"income" for a taxation year is thought of as
commencing with "gross profit" then the
"cost" of the property bought is not an amount that is
"deductible" in its computation. When, moreover, one
thinks of applying section 12(3) to a trader whose transactions
are so numerous or of such a character as to dictate the use of
the proceeds of sales less cost of sales formula, then, in the
"computation" of the "taxpayer's income for a
taxation year" there is no deduction, at least as such, of
the cost of the goods that were sold in the year. ...
[15] As I understand the principle
established by Jackett C.J. in Oryx and confirmed by the
Supreme Court of Canada in Shofar, when computing the
income of a trader, any outlay or expense which becomes part of
the cost of inventory is taken into account when computing
"gross profit" but is not deductible in computing
income. As described in Oryx, gross profit is determined
by deducting from aggregate proceeds of sales for the year the
"cost of sales" which is computed by adding the value
of opening inventory to the cost of purchases in the year, and
then subtracting the value of closing inventory at year end.
[16] In this appeal, the parties have agreed
that the amount $2,421,059 is the pro rata portion of the
capitalized interest ($2,850,637) which is referable to the
condominium units sold in 1995, 1996 and 1997. Therefore, the
amount $2,421,059 was part of the cost of goods sold and was part
of the cost subtracted in computing gross profit for 1995, 1996
and 1997. According to paragraph 13 of the ASF, the amounts
subtracted each year as part of the Appellant's cost of goods
sold were:
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1995
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$1,127,941
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1996
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937,508
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1997
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355,610
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$2,421,059
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[17] If the above amounts were part of the
cost of goods sold (as stated in paragraph 13 of the ASF), then
they were deducted in computing gross profit and, in accordance
with Oryx and Shofar, they were not deducted or
deductible in computing income or taxable income. Returning to
the words in subsection 212(13.2), the amounts in question were
not "deductible in computing" the Appellant's
"taxable income earned in Canada for any taxation
year". The appeal is allowed, with costs, and the assessment
for the Part XIII tax is vacated.
Signed at Ottawa, Canada, this 15th day of October, 2004.
Mogan J.
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