I.S.E. Canadian Finance Ltd. v. Minister of National Revenue, [1986] 1 CTC 2473, 86 DTC 1344 (TCC)

Brulé, T.C.J.:—These are appeals from reassessments of the 1977 and 1978 taxation years of the appellant in which the Minister claimed the appellant realized capital gains respecting foreign exchange of $13,383,350 in 1977 and $1,832,847 in 1978. In addition, except for some minor adjustments, none of the appellant’s foreign exchange losses claimed on its United States payables were allowed to be deducted in whole or in part from income for three taxation years, being $60,530 in 1976, $202,299 in 1977 and $174,636 in 1978. Various deferred finance costs and accrued service charges that had been deducted by the appellant in computing its income for the years in question were disallowed. Further reassessments making minor adjustments were subsequently issued for the years involved.

Issues

The principal point in issue is whether or not the foreign exchange gains or losses of the appellant arising from the exchange of United States for Canadian dollars is income or capital in nature. If the gains or losses are deemed to be capital when should such be reported pursuant to the Income Tax Act?

Facts

The appellant is an Ontario corporation and a wholly-owned subsidiary of International Standard Electric Corporation which in turn is a wholly- owned subsidiary of I.T.T. Holdings Inc. which in turn is a wholly-owned subsidiary of International Telephone and Telegraph Corporation, the latter three corporations all being corporations incorporated pursuant to the laws of the State of Delaware, one of the United States of America.

The objects for which the appellant was incorporated, as stated in its articles of incorporation, were to deal in or hold various kinds of financial instruments, such as shares, bonds, debentures, notes, negotiable instruments and commercial paper, and to engage in ancillary activities in connection therewith.

At all relevant times, the business of the appellant consisted of:

(1) borrowing funds from arm's length parties;

(2) loaning funds to its Canadian affiliates; and

(3) reloaning funds, initially loaned to some of its Canadian affiliates, to other of its Canadian affiliates.

Special attention was given to only certain transactions entered into by the appellant during the 1976, 1977 and 1978 taxation years. While greater particulars were provided by the respondent in his replies to the notices of appeal, the outline provided by the appellant, which was sufficiently detailed for these transactions, was as follows:

(1) in 1976 the Appellant borrowed money secured by the issuance of notes and debentures, totalling $110,000,000 (U.S.) in principal amount, on the Eurodollar markets (referred to as the “U.S. Payables”);

(2) the net proceeds of $107,750,000 (U.S.) of the issuance of debt described in paragraph (1) above were lent in May and August of 1976 to ITT Industries of Canada Ltd. ("ITTI”), a Canadian affiliate of the Appellant, at commercial rates of interest;

(3) in October of 1977, ITTI repaid the U.S. dollar amounts owed by it to the Appellant and the Appellant thereupon loaned the same amounts, on the same terms as had existed on the loans made to ITTI, to Rayonier Canada (B.C.) Limited (‘‘Rayonier B.C.”), a Canadian affiliate of the Appellant;

(4) in October of 1977 the Appellant borrowed money secured by the issuance of an interest-bearing Guaranteed Note with a principal amount of $5,000,000 (U.S.) to Westdeuche Landesbank Girozentrale and thereupon loaned the same amount to Rayonier B.C. on the same terms;

(5) in June of 1978, Rayonier B.C. in turn repaid the U.S. dollar amounts owed by it to the Appellant and the Appellant thereupon loaned the same amounts to Sheraton Hotels Limited (Sheraton), a Canadian affiliate of the Appellant, at commercial rates of interest.

(In my opinion it was probably as a result of these transactions that the reassessments were based.)

In order to eliminate from its money-lending business the risk of loss through foreign exchange fluctuations which would arise if the value of the Canadian dollar fell relative to the United States dollar before the time of repayment of the U.S. dollar loans by the taxpayer, the amounts lent by the Appellant from time to time to ITTI, Rayonier B.C., and Sheraton were also denominated in U.S. currency. These amounts are hereafter referred to as the “U.S. Receivables".

At all times, the Appellant prepared its financial statements in accordance with generally accepted accounting principles ("GAAP”).

In preparing the financial statements, amounts receivable and payable by the Appellant in foreign currencies were translated into Canadian dollars at year-end exchange rates. Changes from year to year in the translated amount of amounts receivable or payable by the Appellant due to changes in the applicable foreign exchange rate were reported in Appellant’s Statement of Income in its financial statements as loss (or gain) on foreign exchange. This method of recording the effect of changes in foreign exchange rates (referred to as the “Accrual Method”’) is in compliance with GAAP.

The losses on foreign exchange as set out above were deducted by the Appellant for the indicated taxation years in computing its income pursuant to section 9 of the Income Tax Act (Canada) (the "Act"). These losses on foreign exchange were the difference between accrued foreign exchange gains arising on the U.S. Receivables and accrued foreign exchange losses arising on the U.S. Payables, both due to an appreciation of the U.S. dollar relative to the Canadian dollar.

Appellant's Position

Evidence disclosed that the transactions delineated above were but a fraction of the appellant’s involvement with lending to its affiliates. During the periods involved in these appeals, there were some 1,150 separate borrowings and loans made involving 4,600 separate transactions, many at the same times to different affiliates in different currencies.

Clearly, it was argued, that the appellant was in a business and that business was the money-lending business. It always borrowed funds at arm’s length, never borrowing from an affiliate.

The dealings of the appellant were such that it almost entirely eliminated foreign gains by matching payables and receivables by formal contracts, as evidenced by the exhibits tendered.

In his statement of reasons in support of appeal, counsel set out and enlarged upon the following at the hearing:

Gains and Losses were on Income Account

The U.S. Receivables of the Appellant were used in the normal business operations of the Appellant, and were regularly turned over in the course of the Appellant’s loaning and reloaning activities. Accordingly, the U.S. Receivables constituted circulating capital of the Appellant.

The U.S. Payables of the Appellant were issued for the purpose of creating or increasing circulating capital of the Appellant, the moneys raised through issuance of the U.S. Payables were in fact used in accordance with that purpose, and the U.S. Payables were deliberately denominated in the same currency and issued on similar terms as were the U.S. Receivables. The U.S. Payables accordingly constituted part of the circulating capital of the Appellant.

Foreign currency gains and losses arising on circulating capital are on income account and are not capital gains or losses. As stated in Dominion Steel & Coal Corporation Limited v. Minister of National Revenue, 57 D.T.C. 147 at page 150 (T.A.B.),

. . . the line that divides capital from income in exchange profits is the same as that which divides capital and income in any other sense. If the exchange profit is made on funds which are fixed capital as opposed to circulating capital, it is not taxable. If, however, it arises out of the use of circulating capital or monies in the income-earning process, it is just as taxable as the profit produced by the sale of the goods which those funds are used to acquire.

Where the objects of a corporation are narrowly stated then the fact that re-. ceipts arise directly out of activities carried on pursuant to the corporation’s objects is evidence that those receipts are income from that corporation’s business. In Anderson Logging Company v. The King, 52 D.T.C. 1209 (S.C.C.), Mr. Justice Duff, as he then was, made the following statement at page 1214:

The sole raison d'être of a public company is to have a business and to carry it on. If the transaction in question belongs to a class of profit-making operations contemplated by the memorandum of association, prima facie, at all events, the profit derived from it is a profit derived from the business of the company.

The foreign currency gains arising from settlement of the U.S. Receivables in 1977 and 1978 were realized in the course of the Appellant’s business, and constituted income pursuant to section 9 of the Act and not capital gains pursuant to subsection 39(2) of the Act.

Accrual of Losses

In Canadian General Electric Co. Ltd. v. Minister of National Revenue, 61 D.T.C. 1300 (S.C.C.) and D.W.S. Corporation v. Minister of National Revenue, 68 D.T.C. 5045 (Ex. Ct.), it was held that it was proper to use the Accrual Method in recognizing foreign exchange losses or gains on debts of a non-capital nature. Accordingly, foreign exchange losses accruing on the U.S. Payables were deductible in computing income pursuant to section 9 of the Act in respect of the 1976, 1977 and 1978 taxation years of the Appellant, and foreign exchange gains arising on the U.S. Receivables were includible in income pursuant to section 9 of the Act as they accrued.

The Accrual Method complies with GAAP. In The Bank of Nova Scotia v. Her Majesty The Queen, 80 D.T.C. 6009 at page 6013 (F.C.T.D.) (affirmed in Her Majesty The Queen v. The Bank of Nova Scotia, 81 D.T.C. 5115 at page 5118 (F.C.A.)) Mr. Justice Addy made the following statement:

Generally recognized accounting and commercial principles and practices are to be applied to all matters of commercial and taxation accounting unless there is something in the taxing statute which precludes them from coming into play. The legislator when dealing with financial and commercial matters in any enactment, including of course a taxing statute, is to be presumed at law to be aware of the general financial and commercial principles which are relevant to the subject matter covered by the legislation. The Act pertains to business and financial matters and is addressed to the general public. It follows that where no particular mention is made as to any variation from common ordinary practice or where the attainment of the objects of the legislation does not necessarily require such variation, then common practice and generally recognized accounting and commercial principals and terminology must be deemed to apply.

Since there is no particular provision in the Act requiring a departure from the Accrual Method, the accrued foreign exchange losses of the Appellant for the 1976, 1977 and 1978 taxation years were accordingly deductible from income as determined under section 9 of the Act and the foreign exchange gains were includible in income pursuant to section 9 of the Act as they accrued.

(Counsel for the appellant also offered argument in the event that the Court found that the foreign exchange gains and losses were on capital account and not on income account, but it is not proposed to deal with this aspect.)

Respondent's Position

In addition to arguing that any foreign exchange gains or losses realized by the appellant were capital in nature, counsel for the Minister suggested that the money borrowed by the appellant was not part of a trading operation but was simply offering a service to affiliated companies.

The replies to the notices of appeal set out:

At all material times, the Appellant’s raison d'être was to borrow money in arm’s length transactions for the purpose of lending it to an affiliate. The Appellant was not a "money lender” in the sense that it would not lend money to the public at large. The Appellant lent money only to affiliates, never lending money to more than one affiliate at any given time. The Appellant’s position, relative to affiliates, is that of a conduit through which the affiliates obtain the capital they require to meet their financial obligations.

While the appellant showed that it had income from an active business as set in the forms 7TWC sent out by Revenue Canada to the appellant, the Minister’s counsel pointed out that at trial the Court was not bound by assumptions made in assessments or reassessments, and in support of this referred to the case of W.L. Craddock and S.C. Atkinson v. M.N.R., [1968] C.T.C. 379; 68 D.T.C. 5254.

The Minister is not alleging that I.S.E. Canadian Finance Ltd. is not a business but rather is not a "money-lender" business. It was admitted that if the Court found that the appellant was a "money-lender" then the Minister’s case fails.

In the replies to the notices of appeal it was assumed that the appellant intended to loan money solely to I.T.T. Industries of Canada Ltd. (an affiliate) but due to two other reorganizations of other affiliates subsequent loans were made as set out above. These few loans then did not give the operation the character of a money-lending business. Also it was pointed out that the appellant did not have offices nor employees and did not deal with the public. It simply provided a service to its affiliates. (Certain precedents were offered in support of this position by the Minister, but in all the cases cited, which I do not intend to review, the circumstances were substantially different from this case under appeal.) Because it was a service business for its affiliates without any intention of making a profit I.S.E. was not a money-lender and therefore its transactions should be deemed to be on capital account and not income. The loans made were only advances of capital, counsel contended.

The respondent put forth that the accrual basis of accounting is not recognized in the treatment afforded capital property under the Income Tax Act, but conceded that if the foreign exchange gains or losses were determined to be income in nature then the appellant is allowed to choose the cash or accrual basis.

Analysis

It was the position of the Minister that if, in fact, the appellant was in the money-lending business then the transactions involved would be on income account, he could use the accrual basis for recording his transactions and for taxation of these, and thus his appeals would succeed. He did, however, maintain that the appellant was not in the money-lending business.

The principles governing the taxability of gains or losses resulting from dealings and fluctuations in foreign exchange are no different from the principles applied to other profits or losses. If exchange profits or losses are attributable to the taxpayer's usual trading activities the result will be treated on income account. If on the other hand the result stems from dealings in capital assets, the result is not income but is on capital account.

In the present case there is no doubt that the appellant was incorporated to deal with its affiliates by borrowing funds at arm's length and loaning these funds to various affiliates. Its inventory from time to time was simply funds available to loan to its affiliates. Often the currency involved was United States dollars, and because of fluctuations in the foreign exchange rates, profits or losses resulted.

If it suited the convenience of the group of affiliated companies to form the appellant for the intended purposes as set out in the objects of its articles of incorporation (supra) then it is not necessary that it either make a profit itself, nor that it deal with the public, although it was not prohibited from so doing. If the company can operate without permanent employees then this is no prohibition to its carrying on its intended purposes.

In the pleadings only certain isolated cases were described in the total of the appellant’s activities. Admittedly they gave rise to the reassessments, but by themselves do not properly indicate the magnitude of the appellant's activities. I do not believe that the respondent realized the extent of the appellant’s loan dealings. As set out during the years involved there were some 4,600 transactions in similar time periods, and by Exhibit A-2, there was shown that the appellant engaged in excess of 3,000 loans involving some 12,000 transactions in borrowing, loaning, collecting on the loans and repayment of the funds borrowed. Can it be said then that the appellant was not in the money-lending business? I think not. As the Minister’s counsel conceded, if the appellant was in the money-lending business his appeals would succeed. This is the only conclusion to arrive at, if for no other reason than, the extent of the appellant’s loaning activities. I.S.E. Canadian Finance Ltd. was an active business; it did nothing other than borrow and loan funds and did this extensively. Therefore it must be considered that all its activities were properly attributed to income account and correctly treated on an accrual basis.

It is not necessary to pursue the arguments advanced by both parties if the Court found that the transactions were on capital account, nor to review all the jurisprudence involved in this argument, nor all involved in the "income" argument.

The appeals are allowed and the matter is referred back to the respondent for reconsideration and reassessment. The appellant is entitled to costs to be taxed.

Appeals allowed.