Bonner T.C.J.:
The Appellant is a corporation continued under the laws of Canada with head office in Calgary, Alberta. It carries on transportation and other businesses directly and through subsidiary corporations. It appeals from an assessment under the Income Tax Act for 1990 taxation year. Notice of the Assessment is dated June 20, 1995. By the assessment, the Minister of National Revenue disallowed part of a deduction claimed by the Appellant under paragraph 20(1 )(c) of the Income Tax Act as interest expense. The issue is whether the Appellant is entitled to deduct interest pursuant to that provision in the amount required to be paid under certain debentures denominated in foreign currency or whether the deduction is to be reduced by gains from dealings in foreign exchange which were closely linked to the foreign currency borrowings,
The disallowed interest was payable under two separate issues of debentures. One was denominated in New Zealand dollars. The other was denominated in A$. Neither issue was a response to a need for capital in the form of the currency which was borrowed. The Appellant required and used C$ and US$ for purposes of its business. In each case the Appellant converted the proceeds of the debenture issue into C$ immediately upon receipt of the borrowed funds. At the same time it entered into contracts with financial institutions unrelated to the purchasers of the debentures to secure the future delivery of the foreign exchange necessary to make the periodic payments of interest called for by the debentures and to retire the principal on maturity. The cost to the Appellant in C$ of the foreign exchange required to repay the principal amount of the loans was thus fixed or locked-in at the very outset and was, in each case, very considerably less than the C$ proceeds received by the Appellant in exchange for the foreign money which it had borrowed. I will refer to the amounts by which the C$ proceeds exceeded the C$ cost of repayment of principal (as fixed by contract) as the locked-in gains.
The interest which the Appellant sought to deduct in computing its income was the cost to it in C$ of the interest which it was legally obliged to pay and did in fact pay as required by the terms of the debentures.
The rates of interest payable under the debentures were substantially higher than the Appellant would have been obliged to pay had it borrowed the money directly in C$. Each borrowing and the foreign currency transactions associated with it was designed, I infer, to satisfy a need for borrowed capital in a way which would inflate the amount of interest fully deductible under paragraph 20(1)(c) while providing an offset to the higher interest costs in the form of a locked-in gain to be realized on the sale of the borrowed foreign currency. In was the Appellant’s intention to treat the locked-in gains when realized as capital gains.
The economic circumstances which made the transactions possible are summarized, accurately I think, by the witness Professor Daniel Thornton as follows:
...because inflation rates were higher abroad than in Canada when the bonds were issued, the stated (nominal) foreign interest rates, denominated in foreign currency, exceeded Canadian interest rates on comparable bonds. At inception of the loans, however, CP would expect to be compensated for the differential because the company would expect to pay future interest and principal amounts in devalued NZ-dollars and A-dollars.
NZ$ for New Zealand dollars.
CP locked in this offsetting compensation by taking long positions in forward currency contracts, in which the forward exchange rates were “discounts” compared with the spot exchange rates that existed when CP issued the debt.
In making the assessment in dispute the Minister of National Revenue deducted from the interest claimed under each debenture an amortized portion of the locked-in gain. That assessing action mimicked the accounting treatment adopted by the Appellant in its domestic financial statements. The accounting treatment was consistent with, if not dictated by generally accepted accounting principles (GAAP) as defined by the Canadian Institute of Chartered Accountants Handbook. The Appellant, in the statement of income in its accounts, reported interest on long-term debt under the heading “fixed charges”. The locked-in gain was recorded separately as “exchange gain on long-term debt”. A note to the 1990 financial statements states:
...under swap agreements, the interest and principal payments to be made with respect to the New Zealand dollar denominated 16.80% Debentures and the Australian dollar denominated 16.125% Debentures, both due in 1994, have been converted into fixed amounts of Canadian dollars, resulting in effective interest rates over the life of the Debentures of 10.25% and 9.94% respectively.
The parties filed a very helpful Agreed Statement of Facts from which the following description of the two sets of debenture and foreign exchange transactions is derived. In order to raise Canadian funds for use in its business the Appellant in 1987 undertook a financing transaction proposed and eventually arranged for it by Goldman Sachs & Co. The financing transaction closed on December 1, 1987. and the following contracts were entered into:
(i) The Appellant issued by private placement to the Long Term Credit Bank of Japan and Mitsui Trust and Banking Company Limited, NZ$ 125,000,000 aggregate principal amount debentures due on December 1, 1994 with interest payable semi-annually at a rate of 16.80% per annum. The debentures were issued at a 2% premium or NZ$ 2,500,000.
(ii) The Appellant entered into a Master Forward Agreement with The Sumitomo Bank Limited (“Sumitomo”) whereby the Appellant sold NZ$ 126,562,500 (i.e., proceeds of NZ$ 127,500,000 less issue costs of NZ$ 937,500) for CAD$ 103,186,406 based on the spot rate on that date and, under a series of forward transactions, the Appellant purchased New Zealand dollars in exchange for Canadian dollars on the interest payment dates and the maturity date under the New Zealand debentures.
The parties to the New Zealand debentures and the Master Forward Agreement were unrelated to each other. The parties to the New Zealand debentures and the Master Forward Agreement carried out the transactions as contemplated by those agreements.
For accounting purposes but not for tax purposes, the Appellant amortized into income over the life of the New Zealand debentures a foreign exchange gain based on the final transaction under the Master Forward Agreement to acquire NZ$ to repay the principal amount of the New Zealand debentures. For 1990, the amount amortized into income was C$ 3,532,982.
In computing its income for accounting and tax purposes for each year that the New Zealand debentures were outstanding, the Appellant deducted an amount equal to the C$ payable to Sumitomo in the year pursuant to the forward contracts to purchase NZ$ to pay interest on the New Zealand debenture. For 1990, the amount deducted was C$ 14,188,475. The reassessment of June 20, 1995 disallowed the Appellant’s deduction for 1990 to the extent of C$ 3,533,982.
In order to raise Canadian funds for use in its business the Appellant in 1989 undertook a financing transaction proposed and arranged by RBC Dominion Securities Inc. The proposal involved the same essential concepts as the New Zealand debentures and Master Forward Agreement proposed and arranged by Goldman Sachs & Co., except that the currency in which the debentures were issued was A$ and the A$ principal amount and liabilities for interest and repayment of principal were to be converted into Japanese yen and the Japanese yen proceeds and liabilities for Japanese yen were to be swapped into C$ payments.
The transaction closed on April 21, 1989 and the following contracts were entered into:
(i) The Appellant issued by private placements to a number of different banks and financial institutions, A$ 260,000,000 aggregate principal amount debentures due on April 21, 1994 with interest payable semiannually at a rate of 16.125% per annum. The debentures were issued at a 2% premium or A$ 5,200,000.
(ii) The Appellant entered into a Master Swap Agreement with Morgan Guaranty Trust Company of New York (“Morgan”) wherein:
A. The Appellant exchanged the Australian dollar principal amount for Japanese yen at the spot rate of exchange,
B. The Appellant entered into a series of forward contracts to purchase Australian dollars using Japanese yen on the interest payment dates and the principal maturity date under the Australian debentures,
C. The Appellant agreed to swap the Japanese yen proceeds for Canadian dollars at the spot rate on the date of issue and to exchange Canadian dollar payments for Japanese yen for its obligations under the Japanese yen/Australian dollar forward contracts, and
D. The Appellant entered into an interest rate swap arrangement with Morgan.
The Appellant and Morgan mutually agreed to terminate the interest rate swap aspect of the Master Swap Agreement in 1991. The parties to the Australian debentures and the Master Swap Agreement were unrelated to each other. Apart from the interest rate swap which was terminated in 1991, the parties to the Australian debentures and the Master Swap Agreement carried out the transactions as contemplated by those agreements.
Once again, for accounting purposes but not for tax purposes, the Appellant amortized into income over the life of the Australian debentures a foreign exchange gain based on the final transactions under the Master Swap Agreement that were to occur on the same date as the maturity of the Australian debentures. For 1990, the amount so amortized was C$28,451,233. In computing its income for accounting and tax purposes for each year that the Australian debentures were outstanding, the Appellant deducted an amount equal to the C$ payable to Morgan in the year pursuant to the Master Swap Agreement, except for the C$ swap payment made in the year of maturity to re-acquire the Japanese yen swapped with Morgan at the commencement of the Master Swap Agreement. For 1990, the amount deducted was C$57,228,716, of which C$3,421,867 related to the interest rate swap. The reassessment of June 20, 1995 disallowed the deduction for 1990 to the extent of C$31,873,101, of which C$3,421,867 related to the interest rate swap.
In the Agreed Statement of Facts the Respondent acknowledged that the Appellant’s deduction in 1990 in respect of the interest swap should not have been disallowed. That concession will of course be reflected in the judgment.
The Minister of National Revenue assessed tax on the basis that the disallowed interest “reflected” payments on account of principal and could not be regarded as a reasonable amount in respect of the amount paid or payable by the Appellant pursuant to its obligation to pay interest on the borrowed money. He found or assumed that the deduction of the disallowed interest on the New Zealand debentures would unduly or artificially reduce the Appellant’s income and invoked section 245 of the Act as it read prior to the amendment effected by S.C. 1988 c.55. As well, he found that section 245 as amended and applicable to transactions entered into on or after September 13, 1998 prohibits the deduction of “...an amount greater than the actual amount of interest paid or payable”.
The relevant statutory provisions are:
a) Paragraph 20(1)(c) which reads in part:
Notwithstanding paragraphs 18(l)(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) an amount paid in the year or payable in respect of the year (depending upon 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 (other than borrowed money used to acquire property the income from which would be exempt or to acquire a life insurance policy),
or a reasonable amount in respect thereof, whichever is the lesser.
b) Subsection 9(1) of the Act which reads as follows:
(1) Subject to this Part, a taxpayer’s income for a taxation year from a business or property is his profit therefrom for the year.
It is not necessary to refer to the provisions of section 245 of the Act in either form.
It was the position of the Appellant that it was entitled under paragraph 20(1)(c) to deduct the full amount of the interest which it was legally obliged to pay under the debentures. That amount is to be determined by reference to the legal results of the Appellant’s transactions and not to some approximation derived by combining the economic results of the borrowing transactions and the associated foreign exchange dealings. The word interest is to be given its ordinary meaning. The foreign exchange dealings were required by a corporate policy of the Appellant intended to limit the Appellant’s exposure to the risks attached to liability denominated in foreign currency. It is the purpose underlying the use of the borrowed money and not the purpose for which it was borrowed which is determinative under paragraph 20(1)(c). The conversion of the borrowed money into a currency which is used to earn income cannot deprive the borrowed money of an income earning purpose. Here the borrowed money was used for the purpose of earning income from the Appellant’s business. The amortization of the locked-in gains on the two foreign exchange contracts for financial statement purposes does not, even under GAAP, transmute those gains into some form of negative interest. The domestic financial statements prepared in accordance with GAAP are not an embarrassment. Income for purposes of GAAP is not the same as income for tax purposes.
It was argued further that the interest rates under the debentures were reasonable market rates for debentures in the foreign currency having regard to the terms and conditions and to the economic standing of the Appellant. The “cost of borrowing” in the foreign currency was, it was argued, in the case of the New Zealand issue, below, and in the case of the Australian issue, only slightly greater than the cost of a comparable C$ borrowing. The locked-in gains on the foreign exchange contracts were not earned by currency speculation; they were, in 1990, the taxation year in issue, unrealized capital gains which could not reduce the amount of interest deductible in the year in computing income for tax purposes.
It was the position of the Respondent that the borrowing and foreign exchange transactions were inter-related. In computing income from the Appellant’s business profit must be determined on ordinary commercial principles (subject to any relevant specific statutory direction). Paragraph 20(1 )(c) permits, by way of exception to paragraph 18( 1)(b) of the Act, the deduction in computing profit of the “financing cost” of using borrowed money to earn profit and must be applied with that statutory context in mind. Whether the locked-in gain is to be netted against interest expense or is to be viewed separately the result is the same, namely, that gain must be recognized as income over the life of the loan. The Respondent relied secondarily on anti-avoidance provisions, former subsection 245(1) in the case of the NZ$ transactions and the current section 245 in the case of the Australian transactions.
In support of the argument that the locked-in gains on the foreign exchange contracts were to be amortized and netted against interest cost, the Respondent asserted that the Appellant sought and secured the combined result of the borrowing and hedging transactions. In this regard the Respondent relied in particular on the fact that the Appellant did not hold the money borrowed for any appreciable period of time and indeed took pains to ensure that its exposure to fluctuations in foreign exchange rates was contractually eliminated. The Respondent argued that the “payment stream” which the Appellant arranged under the borrowing and hedging contracts was the appropriate measure of the paragraph 20(1 )(c) deduction. Counsel relied on the Appellant’s domestic accounting treatment which, as required by GAAP in order to avoid understatement of income, treated the amortized amount as a reduction of interest expense.
While argument in this case was underway the Federal Court of Appeal handed down its decision in Shell Canada Ltd. v. R.4 The Court of Appeal reversed a decision of this Court which had allowed an appeal from an assessment of income tax and found that paragraph 20(1 )(c) permitted the deduction of the full amount of interest paid or payable under a hedged foreign currency borrowing transaction which was strikingly similar to the two now in question. Not surprisingly counsel for the Respondent argued that the decision of the Court of Appeal was determinative of the outcome in the present case. Counsel for the Appellant argued that Shell was wrongly decided, should not be followed, and, in any event, is distinguishable.
If I had been able to decide this appeal free of the constraints imposed by the decision of the Court of Appeal in Shell I would have approached the case on the basis that:
a) Provided all conditions laid down by paragraph 20(1)(c) are satisfied that provision confers a statutory right to deduct interest irrespective of whether ordinary commercial principles of accounting or, a fortiori, GAAP might point to a different result.
b) The word “interest” as used in paragraph 20(1 )(c) means compensation payable by debtor to creditor for use by the former of the latter’s money. Absent any special arrangement between debtor and creditor the computation of interest is unaffected by profits, losses or other consequences to the debtor of the use made by him of the borrowed money.
c) All paragraph 20(1 )(c) conditions are satisfied here:
i) there is no suggestion that the interest which the Appellant seeks to deduct was not payable in respect of the 1990 taxation year;
ii) there is no suggestion that the New Zealand and Australian debentures did not impose on the Appellant an enforceable legal obligation to pay interest to the holders thereof at the rates of 16.80% and 16.125% per annum respectively;
iii) there is no suggestion that the borrowed money was not converted into C$ immediately after the issuance of the debentures and thereafter used for income earning purposes as outlined in the testimony of the witnesses W.R. Fatt and Brian McDiarmid;
iv) while there is clear evidence that the interest rates payable under the terms of the debentures were substantially higher than the Appellant would have been obliged to pay for a direct C$ borrowing, those rates did not exceed market rates for borrowing in NZ$ and A$. In considering the question whether a reasonable amount in respect of the interest which the Appellant was obliged to pay is some lesser amount than claimed it must be remembered that borrowing in foreign funds, although more expensive than a direct C$ borrowing, enabled the Appellant to engage in adventures in the nature of the trade of a currency dealer and thereby earn very substantial gains which, when realized, would form part of the Appellant’s ordinary business income. The borrowing transactions were clearly on capital account but it does not follow that the foreign exchange transaction must be characterized in the same way for tax purposes simply because they are related to those borrowing transactions. The borrowing in foreign currency did not give rise to an accretion to capital. Other transactions between the Appellant and parties different from the lenders generated the locked in gains.
d) The Appellant’s decision to borrow at all was made for business reasons. The Appellant’s decision to effect the borrowing in foreign currency was an attempt to lower its overall borrowing costs, when viewed on a purely economic basis, by structuring the transactions to secure
i) enhanced paragraph 20(1 )(c) deductions,
ii) the locked-in gains, and
iii) anticipated capital gains treatment of the locked-in gains.
The tax planning element of the transactions cannot defeat the Appellant’s claim for a deduction to which it is otherwise entitled:
It is well established in the jurisprudence of this Court that no “business
tax:7
I turn next to the Appellant’s argument that Shell is distinguishable. In Shell the taxpayer wanted to raise US$100,000,000 for use in its business. With that objective in view it issued NZ$ debentures in the total amount of $150,000,000. The debentures were for a term of five years and bore interest at 15.4% payable semi-annually. At the same time the taxpayer entered into foreign exchange agreements for the immediate purchase of US$ with the proceeds received from the issue of the debentures and, as well, the sale of US$ and purchase of NZ$ in the amounts and at the times required to meet its obligations to pay interest semi-annually and to repay the principal on maturity. The foreign exchange transactions enabled the taxpayer to lock-in a US$ cost of repaying the principal which was US$21,165,000 less than the US$102,014,438 proceeds received from the conversion of the money which it had borrowed. Had the taxpayer borrowed the US$100,000,000 directly the market rate of interest would have been 9.1%. The taxpayer sought to deduct in computing its income for 1992 and 1993, the year of maturity of the debentures, the semi-annual interest payments which it calculated to be the C$ equivalent of the US$ needed under the forward contract to buy the NZ$ required for interest payments. In assessing tax the Minister of National Revenue disallowed a portion of the interest expense so claimed. In effect he limited the deduction to the 9.1% market rate which would have applied to a direct US$ loan. As well the Minister treated as income the locked-in foreign exchange gain which the taxpayer realized on the purchase on the funds required to repay principal.
The Court of Appeal held that the taxpayer’s interest deduction under paragraph 20(1)(c) was limited to 9.1% on the basis that:
(a) the “true” interest payable was 9.1% and the excess over that amount was a repayment of principal;
(b) the NZ$ borrowed by the taxpayer were not used for the purpose of earning or producing income because the NZ$ were borrowed primarily to avoid tax as well as to get the US$; and
(c) 9.1% was the reasonable rate of interest.
The Court of Appeal found as well that on repayment of the NZ$ loan, the taxpayer realized a gain on capital account. The principal reasons of the Federal Court of Appeal were delivered by Linden J.A.; Strayer and Stone J.J.A. expressed agreement.
With regard to the first point Linden J.A. stated:
[48] The 15.40% interest that Shell paid is not the true interest rate. If it were, Shell would not have paid it. The true interest rate is the real rate paid when the transactions are looked at in their entirety. The Tax Court Judge dismissed the notion that the two transactions had to be looked at in tandem in order to determine correctly their tax treatment. I disagree with this approach for two reasons. First, paragraph 20(1 )(c) requires that two transactions be undertaken by the taxpayer. Money has to be borrowed and it then has to be used for the purposes of earning income. There will always be a pair of transactions that the Court will have to consider to determine whether the deductions fall within the meaning of the provision. Second, in Shell’s case, it is clear that the NZ money was not borrowed as capital in the income earning sense. The financing arrangement was aimed at securing US$ to be employed as capital in the business. The foreign exchange contracts were a necessary component of the plan to secure US$ funding at a commercial rate. In the result, the NZ debentures cannot be looked at in isolation as was done by the Trial Judge. There was no use of borrowed money that qualified under paragraph 20( 1 )(c) unless the conversion into US$ is integrated into the analysis.^
[49] Therefore, the assessment of what exactly is the “interest” must include the predetermined gain realized at the retirement of the loan, brought about by the discounted forward rate on the currency.
In the present case the Minister deducted from interest at the rate stated on the face of the debentures an amortized amount which represented the “pre-determined gain realized on the retirement of the loan”. The passage just cited from the reasons of the Court of Appeal makes it abundantly clear that I must hold that the Minister was justified in doing so for the assessment now under appeal proceeded on exactly the same principle.
I cannot give effect to the argument that the decision of the Federal Court of Appeal in Shell rested on an economic substance over legal form doctrine which is wrong and should not be followed. It must be remembered that appeals lie to the Federal Court of Appeal from decisions of this Court and not the reverse. This Court is bound to follow Shell until such time as the decision is set aside by the Supreme Court of Canada. While an application for leave to appeal to that Court is pending no assumption can be made about the outcome of the application or of the appeal, if leave is granted. There is this to be added:
It is fundamental to the due administration of justice that the authority of decisions be scrupulously respected by all courts upon which they are binding. Without this uniform and consistent adherence the administration of justice becomes disordered, the law becomes uncertain, and the confidence of the public in it undermined. Nothing is more important than that the law as pronounced, ... should be accepted and applied as our tradition requires; and even at the risk of that fallibility to which all judges are liable, we must maintain the complete integrity of relationship between the courts.^ I
Counsel for the Appellant sought to distinguish Shell on the basis that:
...the Court’s conclusion regarding the deductibility of interest under paragraph 20(1 )(c) was based on a finding that the transaction Shell undertook was not reasonable when compared with a “direct U.S. $ borrowing” (p. 30) which would have had a pre-tax “market rate of interest” “in the order of 9.1% per annum” (p. 3).
that
This specific finding allowed the Court to uphold the Minister’s reassessment of Shell on the basis that interest beyond the market rate for a direct loan of U.S. dollars would be disallowed (p. 4).
that
to the extent these “unique/facts found in the Shell case are not present in any other case. Shell is not applicable.”
and that
There is no evidence in this case upon which this Court could conclude that the Appellant’s pre-tax borrowing cost was not reasonable when compared to a direct Canadian dollar borrowing.
The distinction which the Appellant seeks to draw is not of assistance because the Court of Appeal relied on the “reasonable amount” limitation in paragraph 20(1 )(c) as an independent ground and not as part of the conclusion that interest within the meaning of 20(1 )(c) must be computed after the foreign exchange gain is taken into account. Furthermore the Appellant cannot rely on the supposed absence of evidence that the rates of interest payable on its debentures were unreasonably high. The Reply to the Notice of Appeal pleads that the assessment rested on a finding or assumption that:
...the disallowed interest is not a reasonable amount in respect of the money borrowed by the Appellant;
The onus of establishing that the assumption was incorrect rests on the Appellant which can hardly rely on its failure to adduce evidence to discharge that onus. Finally I will observe that the principle on which the Court of Appeal based its decision on the paragraph 20(1)(c) reasonableness limitation was that what is reasonable is to be measured by reference to a reasonable rate of interest for the borrower to pay and not the rate which it is reasonable for a lender to charge. The reasons of Linden J.A. at paragraphs 56 to 58 are clear in this regard. It is therefore not enough for the Appellant to say that the rates fixed by the two issues of debentures did not exceed market rates for borrowing in the relevant foreign currency.
The Respondent has succeeded in respect of all issues with one minor exception which has been disposed of on consent. The appeal will therefore be allowed but with costs to the Respondent.
Appeal dismissed.
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