Teskey T.C.J.:
1 The Appellant appeals from reassessments by the Minister of National Revenue (the “Minister”) of income tax in respect of its 1986, 1987 and 1988 taxation years.
Issues
2 The issue to be decided is whether the Appellant was entitled, in computing the undepreciated capital cost of property of Class 29 of Schedule II of the Income Tax Act Regulations (the “Regulations”), to include the capital cost of the property that was sold and repurchased, and whether the Appellant was entitled to claim capital cost allowance thereon in computing its income for the taxation years in issue for purposes of Part I of the Income Tax Act (the “Act”).
3 The Respondent's position to this issue, as stated in paragraphs 8 and 9 of the Reply to the Notice of Appeal was:
8. The Respondent submits that the cost to the Appellant of the Property, reacquired by it from Wascana on June 30, 1986, was only $1,054,050. the payment by the Appellant to Wascana of $595,050, the payment immediately thereafter to Wascana and the agreement that Wascana would not recover on its receivables were a deceit upon the Minister of National Revenue designed to mask the true cost to the Appellant of the Property, being $1,054,050 and, accordingly, the Minister of National Revenue properly disallowed the capital cost allowance claimed on the capital cost of Property in excess of $1,054,050.
9. Alternatively, he submits that the effect of the transactions, which was to increase the Appellant's capital cost of the Property and consequently, the Appellant's capital cost allowance deductions in subsequent years, was artificial and resulted in an artificial reduction to the Appellant's income. In accordance with subsection 245(1) of the Act, the increased capital cost allowance deducted by the Appellant was properly disallowed.
4 The Appellant's position was that for the Court to determine the above stated issue, that it would have to determine two subsidiary issues, namely:(a) whether the Appellant's reacquisition cost in excess of $1,054,050 (ie. $595,050) can be prevented from being added to the undepreciated capital cost of the Appellant's Class 29 pool on the basis that this portion of the capital cost of the property was not made or incurred for the purpose of earning income;
(b) whether subsection 245(1) of the Act prohibited the Appellant's capital cost allowance deductions.
5 At the hearing, the parties filed with the Court a Written Agreed Statement of Facts (the “A.S.F.”). Counsel for the Appellant also read into evidence certain questions and answers from the examination for discovery of the Minister's representative (Exhibit A-1). Counsel for the Respondent also read into evidence certain questions and answers from the examination for discovery of the Appellant's representative (Exhibit R-2). The 22 paragraphs of facts that the parties agreed upon are:
1. The Appellant is a taxable Canadian corporation as defined in subsection 89(1) of the Income Tax Act (Canada) (the “Act”) and has a taxation year ending on December 31 of each year.
2. Wascana Pipe Line Ltd. (“Wascana”) was organized on or about September 26, 1972 for the purpose of owning and operating a crude oil pipeline carrying crude oil from Regina, Saskatchewan to the U.S. border. Following the organization of Wascana, the Appellant owned 334 Class A Shares in the share capital of Wascana, which represented 33.33% of the issued and outstanding shares of Wascana. On June 3, 1986, the Appellant purchased an additional 167 Class A Common Shares of Wascana from another shareholder such that, following such acquisition the Appellant owned 50% of the issued and outstanding shares of Wascana. The other 50% of the issued shares were held by Murphy Oil Ltd. (“Murphy”).
3. Throughout the period that the Appellant was a shareholder of Wascana, the losses sustained by Wascana were financed, by the Appellant and Murphy, through share subscriptions and shareholder loans.
4. Wascana had substantial non-capital losses which were due to expire on June 30, 1986.
5. Prior to the transactions described below, the Appellant was the 100% owner of a fractionation plant, (“the Depreciable Property”) which it had used in its business to earn income.
6. In order to utilize Wascana's non-capital losses and to prevent them from expiring, Wascana entered into transactions with the Appellant which are described at paragraphs 7 to 16 below. The parties intended that once the first transaction (as described in paragraph 7 below) began, all of the other remaining transactions (described in paragraphs 8 to 16 below) would be completed and in the manner in which it was ultimately carried out.
7. On June 23, 1986, the Appellant transferred a 40% interest in the Depreciable Property to Wascana for $1,650,000, paid by shares valued at $595,050 and a demand promissory note of $1,054,950. Attached herewith as Exhibit “A” is a true copy of the agreement with respect to the transfer.
8. The Appellant and Wascana made an election pursuant to subsection 85(1) of the Income Tax Act with respect to the transaction described in paragraph 7 above. In this election the parties agreed that the fair market value of the property was $1,650,000 and the elected and agreed amounts were each $1,054,950. Attached herewith as Exhibit “B” is a true copy of the said election.
9. The Appellant and Wascana entered into an agreement regarding the operation of the Depreciable Property, which agreement is Exhibit “C”.
10. Pursuant to the agreement in Exhibit “C”, the Appellant paid $1,000 to Wascana on June 30, 1986.
11. For purposes of computing its Undepreciable Capital Cost (“UCC”), within the meaning of subsection 13(21) of the Income Tax Act of its Class 29 pool, for the 1986 and subsequent taxation years the Appellant treated the transfer of the property to Wascana as a disposition of the Depreciable Property for proceeds of $1,054,950 and Wascana treated the transfer as an acquisition of depreciable property for the same amount.
12. On June 30, 1986, the Appellant acquired the 40% interest in the Depreciable Property from Wascana for $1,650,00 and paid Wascana by way of a promissory note of $1,054,950 and a cheque in the amount of $595,050. Attached herewith as Exhibit “D” is a true copy of the agreement with respect to this transaction.
13. The promissory note referred to in paragraph 12 was settled by way of a set-off against the promissory note referred to in paragraph 7.
14. On June 30, 1986, Wascana used the proceeds from the cheque (referred to in paragraph 12) to pay down its existing shareholder loan due to the Appellant. The accounting entries are summarized in a letter to the Appellant from its accountants, Clarkson Gordon, dated July 21, 1986 and which letter is attached herewith as Exhibit “E”.
15. The parties to the transactions agreed that the fair market value of the 40% interest in the Depreciable Property was $1,650,000. The Respondent does not dispute the fair market value figure used by the parties.
16. For purposes of computing its Class 29 “UCC”, within the meaning of subsection 13(21) of the Act, the Appellant treated the acquisition from Wascana of the 40% interest in the Depreciable Property as an acquisition of Class 29 property for a capital cost of $1,650,000 and Wascana, for the purpose of computing its Class 29 “UCC”, treated the transfer as a disposition of property of that class for proceeds of $1,650,000.
17. One of the intended results of the transactions described in paragraphs 7 to 16 was to increase the Appellant's “UCC”, within the meaning of subsection 13(21) of the Act, of the Appellant's Class 29 pool, from $1,054,950 prior to the transactions, to $1,650,000 after the transactions were completed. Also, one of the purposes of the Appellant in acquiring the 40% interest in the Depreciable Property, as described in paragraph 12, was to use the 40% interest in the Depreciable Property to earn income from its business.
18. Upon acquisition of the 40% interest in the depreciable Property from Wascana and in each of the taxation years in issue, the Appellant used the property for the purpose of earning income from its business.
19. In computing its income for the 1986, 1987 and 1988 taxation years, the Appellant made capital cost allowance (“CCA”) claims on the basis that the capital cost of the Depreciable Property acquired by it from Wascana was $1,650,000.
20. The Minister of National Revenue reassessed the Appellant for the 1986, 1987 and 1988 taxation years and reduced the Appellant's claim for CCA by the amounts of $148,762, $297,526 and $148,762 respectively on the basis that the addition to the Appellant's Class 29 UCC pool with respect to the 40% interest in the Depreciable Property was $1,054,950.
21. During an Examination for Discovery of the Respondent, R. Schey, of the Department of National Revenue, Mr. R. Schey stated that in raising the reassessment in issue, the Minister did not assume that “the Transactions constituted a deceit”. In addition, Mr. R. Schey confirmed that in raising the reassessment in issue, the Minister assumed that the transactions were “a real transaction and a legally effective one in all respects, save taxation.”
- 22. With respect to the Minister's assumption regarding the section 85 election described in paragraph 8, supra, Mr. R. Schey's evidence was as follows:
- Page 17, lines 4-18:
Q. Now, sir, I want to take you back to 5(e) ii. To the best of your knowledge, did the assessor ever take the position that the section 85 rollover from Gibson to Wascana was in any way improper?
A. I don't think that was ever addressed, no.
Q. Okay. Did the -- to the best of your knowledge did the Minister ever assume that the cost of the property that went from Gibson to Wascana was anything other than the agreed amount of 1,054,950?
A. I don't ever remember reading anything to suggest anything different.
Q. So the answer is that the Minister did not assume that the cost was anything other than that, correct?
A. To the best of my knowledge, they assume it was correct, yeah.
6 Also attached to the A.S.F. are the actual written agreements referred to therein.
7 I do not propose to reproduce these agreements herein as they only purport to carry out and do, in fact, carry out what is set out in the A.S.F. There is one fact that the Respondent argues is significant in these agreements, namely the agreement referred to in paragraphs 9 and 10 of the A.S.F., which provides in paragraph number 4 thereof, that the Appellant indemnify and hold Wascana harmless from and against all losses, costs, claims, damages and liabilities arising out of or relating to the Class 29 property or the operation thereof.
8 The questions and answers that Counsel for the Appellant read into evidence demonstrated that the Minister would not have reassessed the Appellant if Wascana had been a wholly owned subsidiary. Although I accepted these questions and answers as evidence, I attach no weight to this fact.
9 The questions and answers Counsel for the Respondent read into evidence only related to the Appellant's position which was maintained at trial.
10 During the course of the argument, Counsel for the Respondent agreed to the following facts that are numbered as 25 and 26 and are to form part of the agreed A.S.F. These read:
Analysis Issue No.1
11 Section 20 of the Act, under the heading “Deductions permitted in computing income from business or property” reads:
(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:
12 Subparagraph (a) thereof is the provision for capital cost allowance and reads:
(a) such part of the capital cost to the taxpayer of property, or such amount in respect of the capital cost to the taxpayer of property, if any, as is allowed by regulation.
13 The Appellant argues that the Minister cannot say that the reacquisition costs which bumped its Class 29 CCA pool by $595,050 was not made or incurred for the purpose of earning income because of the agreed facts contained in paragraphs numbers 18 and 19 of the A.S.F.
14 In view of the Respondent agreeing to the facts set out in paragraphs 18 and 19 of the A.S.F., which read:
19. In computing its income for the 1986, 1987 and 1988 taxation years, the Appellant made capital cost allowance claims on the basis that the capital cost of the Depreciable Property acquired by it from Wascana was $1,650,000.
15 I reject the Respondent's position on this point. Paragraph 20(1)(a) of the Act does not allow the Minister to proportion the purchase price of the repurchased assets. I accept the Appellant's position on this point.
Issue No. 2
16 This issue is whether subsection 245(1) of the Act prohibited the Appellant's capital cost allowance bump up. This provision is found in Part XVI of the Act under the general heading Tax Avoidance. Section 245 has the heading “Artificial Transactions” and subsection (1) thereof reads:
(1) In computing income for the purposes of this Act, no deduction may be made in respect of a disbursement or expense made or incurred in respect of a transaction or operation that, if allowed, would unduly or artificially reduce the income.
17 The Respondent argues that there was no change in the legal position of the Appellant in that it started with 100% ownership of the Depreciable Property and ended up with 100% ownership of the same Depreciable Property and thus, there was no economic change.
18 This argument I reject. The Appellant sold assets and received consideration at fair market value and paid the full market value for the assets. This, the Respondent agreed to in paragraph 15 of the A.S.F., which reads:
15. The parties to the transactions agreed that the fair market value of the 40% interest in the Depreciable Property was $1,650,000. The Respondent does not dispute the fair market value figure used by the parties.
19 The result was an economic change in that the Appellant was able to take capital cost allowance on the increased value of its Class 29 pool of assets in the amount of $595,050.
20 I also reject the Respondent's argument based on the Federal Court of Appeal's decision in Hickman Motors Ltd. v. R. (1995), 95 D.T.C. 5575 (Fed. C.A.), as in that case the taxpayer did not acquire the asset for the purpose of gaining or producing income from the said asset.
21 In view of the Respondent agreeing that the 40% interest in the Depreciable Property had a fair market value of $1,650,000 and that the Depreciable Property was used to earn income from a business and that the transactions were real and legally effective in all respects, save taxation, then this appeal fails only on a finding of artificiality pursuant to subsection 245(1) of the Act.
22 In order for subsection 245(1) to disallow a deduction, three conditions must be satisfied, these are:a) that the deduction must result in a reduction of income that is artificial or undue;
b) that the challenged transaction or transactions offend the object and spirit of the Income Tax Act;
c) that the deduction be in respect of “a disbursement or expense”.
23 Estey, J. of the Supreme Court of Canada said in Stubart Investments Ltd. v. R. (1984), 84 D.T.C. 6305 (S.C.C.), at pages 6311 and 6312, under the heading “Business Purpose Test”:
B. Business Purpose Test
What then is the law in Canada as regards the right of a taxpayer to order his affairs so as to reduce his tax liability without breaching any express term in the statute? Historically, the judicial response is found in Bradford Corporation v. Pickles, [1895] A.C. 587where it was stated:
If it was a lawful act, however ill the motive might be, he had a right to do it. If it was an unlawful act, however good his motive might be, he would have no right to do it.
(per Lord Halsbury L.C. at p. 594)
No use of property, which would be legal if due to a proper motive, can become illegal because it is prompted by a motive which is improper or even malicious.
(per Lord Watson at p. 598)
In the field of taxation itself the traditional position was re-echoed in I.R.C. v. Duke of Westminster, [1936] A.C. 1at p. 19 where it was stated:Every man is entitled if he can to order his affairs so as that the tax attaching under the appropriate Acts is less than it otherwise would be. If he succeeds in ordering them so as to secure this result, then, however, unappreciative the Commissioners of Inland Revenue or his fellow taxpayers may be of his ingenuity, he cannot be compelled to pay an increased tax.
and again at page 6319:The effect of interworking of all these considerations or rules may be that a court must apply a taxing statute so as to bar the claim of entitlement to an allowance, deduction or other advantage or benefit where the taxpayer created entities or rights and obligations in order to revise the character, under the statute, of the income or earnings already achieved by the taxpayer. The claim would not necessarily be barred, however, where the new alignment of the taxpayer's affairs is adopted only to reduce or avoid taxation of earnings or income thereafter arising independently from the establishment of the arrangements in question.
24 He then went on to say, at page 6320, under the heading “Sham Test”:
The element of sham was long ago defined by the courts and was restated in Snook v. London& West Riding Investments, Ltd., [1967] 1 All E.R. 518at p. 528. Lord Diplock, at p. 528, found that no sham was there present because no acts had been taken:
...which are intended by them to give to third parties or to the courts the appearance of creating between the parties legal rights and obligations different from the actual legal rights and obligations (if any) which the parties intend to create.
and again at page 6321, he said the following:...There is, in short, a total absence of the element of deceit, which is the heart and core of a sham...
25 Laforest, J., of the Supreme Court of Canada in Mara Properties Ltd. v. R. (1996), 96 D.T.C. 6309 (S.C.C.), said at page 6310:
We agree with the conclusion reached by the Tax Court Judge and Mr. Justice McDonald, the dissenting judge in the Court of Appeal.
26 McDonald, J.A. said in Mara Properties Ltd. v. R., [1995] 2 C.T.C. 86 (Fed. C.A.), at page 90 and as a footnote at the bottom of page 97:
I have reviewed the decisions in Lipson and Moloney, supra, and find that they say in order to qualify as a business, an activity must not only be engaged in a business with a reasonable expectation of profit, but that profit must be anticipated to flow from the business itself rather than exclusively from the taxing statute. Neither of these cases state that every transaction of a business must have a reasonable expectation of profit. If that were the case, then a business could never claim as an expense the cost of any legal of financial advice on how to structure their affairs in order to reduce their tax burden. Consequently, I find that the above jurisprudence should not be extended to apply to every transaction of a business.
Marceau, J.A., said at page 90 that the trial judge quoted the appellant's counsel as follows:Now let's be clear, your Honour. We make no bones about the fact that this was an entirely tax-motivated transaction. We make no bones about the fact that there was no reasonable expectation of profit in property where we acquired it at noon and sold it by dusk for a loss of four and a half million dollars. (Mara Properties Ltd. v. Canada, [1995] 2 C.T.C. 86 at 90 (Fed. C.A.)
27 My colleague Rip, J. found that the taxpayer in Nova Corp. of Alberta v. R. (1995), 95 D.T.C. 599 (T.C.C.), could not be said to have artificially or unduly increased the amount of its loss from the disposal therein, nor purchased and re-sold shares solely for the purpose of acquiring a capital loss. In two different transactions, the taxpayer acquired control of two corporations specifically incorporated to hold corporate shares with high adjusted cost bases and normal market values. The taxpayer disposed of these shares immediately thereafter. The transactions were purely tax driven.
28 In Irving Oil Ltd. v. R., [1991] 1 C.T.C. 350 (Fed. C.A.), the taxpayer interposed a wholly owned subsidiary between itself and the supplier of its crude oil. The subsidiary, Irvcal, purchased crude oil at $2.24 per barrel and immediately resold it to the taxpayer for $2.90 per barrel. It never took possession of and never issued the crude oil it sold to the taxpayer. Rather, agreements between the supplier and Irvcal and the taxpayer provided for “metaphysically sequential, if apparently simultaneous, shifts of ownership”. Irvcal's operating expenses were only23/1000of 1% of the value of its sales, all of which were to the taxpayer.
29 The Federal Court of Appeal, in its unanimous decision, found that Irvcal had no bona fide business purpose and that “what was concocted and carried out was a tax avoidance scheme, pure and simple”. Notwithstanding the determination that the arrangement in issue was a pure tax avoidance scheme (and the facts mentioned above on which the determination was based), the Court of Appeal held that subsection 245(1) of the Act could not apply.
30 In a recent decision of Associate Chief Judge Christie of this Co urt, Shell Canada Ltd. v. R. (IT)G (T.C.C.) (unreported), said at page 9:
To my mind the foregoing is not intended to convey the notion that entering into bona fide business contracts that are motivated by considerations of related tax benefits is to be regarded as divorced from “commercial and economic realities”. In the world of commerce, taxation and tax planning loom large as part and parcel of commercial and economic realities. It is commonplace in Canada and elsewhere for tax considerations and planning to play a pivotal role in the making of important business decisions.
31 This case illustrates that a fair market value payment cannot reduce income unduly or artificially. The taxpayer Shell had borrowed New Zealand dollars at a 15.4% rate of interest and “hedged” its New Zealand borrowing into U.S. dollars by immediately converting the borrowed New Zealand dollars into U.S. dollars and entering into forward foreign exchange contracts to purchase New Zealand dollars with U.S. dollars on the dates its New Zealand principal and interest payments were due. The result of these arrangements was that Shell paid the high 15.4% rate of interest prevailing for New Zealand dollars, but because it was anticipated that the value of New Zealand currency would fall against U.S. currency, by entering into the forward foreign exchange agreements, Shell was able to assure that it would recoup the higher interest costs it incurred by realizing a gain of $21,165,000 on repayment of the loans.
32 My colleague Bowman, J. in Mark Resources Inc. v. R. (1993), 93 D.T.C. 1004 (T.C.C.), considered a tax planning scheme wherein the taxpayer borrowed money in order to lend that money to its U.S. subsidiary. The scheme was implemented so the subsidiary could use its losses before they expired under the U.S. loss carry-forward rules. Judge Bowman found that the overriding purpose of the loans was not to earn income, but rather to permit the subsidiary's losses to be imported into Canada and deducted in computing the parent's income.
33 He said at the top of page 1010:
Considered separately neither of these elements justifies a disallowance of the interest paid under subsection 245(1). The tax considerations that motivated the arrangement by itself do not by themselves bring it within the ambit of subsection 245(1)3. The borrowing at a rate that does not and cannot yield an economic return as a means of achieving a predetermined economic result is in itself not artificial. To hold that this scheme failed for artificiality would be to ignore the decision of the Federal Court of Appeal in Irving. If the Irving scheme was not artificial this one cannot be.
34 The footnote 3 at the bottom of the page reads:
The emotive and somewhat pejorative connotations of such expressions as “tax avoidance scheme” do not assist particularly in a rational analysis of the problem. Even if there were any place in the analysis of the consequences of a tax motivated arrangement for assessing some level of fiscal reprehensibility, which I doubt, I should think that the absorption of business losses within a corporate group would rank rather low. There is nothing particularly sinister about using the rules of a highly specific taxation statute to achieve such a result provided that the transactions are real and legally binding and are not contrary to the scheme of the Act as a whole. It was, after all, a scheme to achieve precisely that objective that was held acceptable by the Supreme Court of Canada in Stubart. There is a world of difference between the creation of artificial deductions and losses out of thin air and the utilization of legitimately incurred losses within a related group.
35 He also said at page 1010:
One final observation must be made. We have here a series of interrelated transactions. The Crown has challenged under subsection 245(1) only one aspect of the entire arrangement, the deduction of interest, on the basis that it results in an artificial or undue reduction of the appellant's income. Yet it has chosen to leave intact the consequences of all but one of the component parts. Either the whole structure falls or it does not. It cannot be dismembered piecemeal. In any fiscally motivated scheme, if no sham is involved, there must necessarily be legally effective steps that have specific tax consequences. The tax results of each of those steps that forms an integral part of the entire scheme must be respected unless the Minister is prepared to say that the scheme as a whole fails.
36 The Supreme Court of Canada in Harris v. Minister of National Revenue (1966), 66 D.T.C. 5189 (S.C.C.), presumed that subsection 245(1) (then 137(1)) could apply to claims for capital cost allowance. This issue was squarely before Justice Addy of the Federal Court - Trial Division, in McKee v. R., [1977] C.T.C. 491 (Fed. T.D.), when he determined that subsection 245(1) cannot be applied to capital cost allowance deductions. However, in view of the Respondent's admission that one of he purposes of the transactions was to use the 40% interest in the Depreciable Property to earn income for its business, subsection 245(1) has not been offended.
37 I reject the Respondent's position that the Consolidated-Bathurst Ltd. v. R. (1987), 87 D.T.C. 5001 (Fed. C.A.)decision is authority to treat the sale from the Appellant to Wascana as not being effective, (because of the indemnification given by the Appellant to Wascana) in light of the facts agreed upon. The Federal Court of Appeal in this decision was dealing with insurance premium expenses. Therein the Court said that since the risk remained with the taxpayer, the premiums paid did not provide bona fide insurance protection. Therefore, the deduction of the insurance premiums resulted in an artificial reduction of the taxpayer's income. Herein, title to the assets passed from the Appellant to Wascana for valid consideration. The indemnification as a term of the contract did not prevent title passing. Wascana received payment for the Appellant's use of the property for the brief period. See agreed fact number 10.
38 Herein, two parties had a financial problem. Wascana had substantial non capital losses which were due to expire on June 30, 1986, which losses had been financed by the Appellant through share subscription. Murphy was in the same financial position vis-à-vis Wascana as the Appellant. Obviously, the operating minds of all three corporations sat down together and said “Is there anything we can do so that the losses suffered by all three can be alleviated?” The answer was yes, namely enter into the series of transactions that they did in fact enter into. They took the Act and applied the provisions thereof to real and effective transactions at fair market value.
39 All prudent taxpayers take into consideration the tax implications of all transactions. This is commercial reality. Just because the taxpayers, by entering into these agreements and completing them, used the Act to their advantage does not in itself create a problem. The commercial reality is that there was substantial potential benefit, namely the Appellant was able to use its non capital losses. I do not believe that these transactions offend the object and spirit of the Act.
40 The appeal is allowed, with costs, and the assessments are referred back to the Minister of National Revenue for reconsideration and reassessment on the basis that the Appellant's Class 29 pool of assets is to be increased in 1986 by the sum of $595,050.
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