Shell Canada Ltd. v. R., [1998] 2 C.T.C. 207, (sub nom. R. v. Shell Canada Ltd.) 98 D.T.C. 6177

Linden J.A.:

Introduction

1 The question to be decided on this appeal is whether a sophisticated financing plan to obtain for Shell Canada Ltd. (Shell) 100 million U.S. dollars, (US$) utilizing a “Kiwi” loan and certain hedging transactions, has succeeded in reducing the tax that otherwise would be payable.

2 Shell needed US$100 million for general corporate purposes. The prevailing market rate for a direct borrowing of US$ was approximately 9.1%. Shell sought ways in which the cost of this financing requirement could be reduced. They accepted a strategy proposed by Goldman Sachs & Co. of New York City which utilized a so-called “Kiwi Loan”. This strategy involved borrowing the needed money in New Zealand dollars (NZ$). The interest cost to Shell would be 15.4%; however, the future rate for NZ$ was discounted against the US$. In other words, the cost to buy NZ$ in the future would be less than the cost to buy them in the present. This meant that Shell would receive more US$ with the proceeds of the loan than it would cost it to repay when the loan became due in the future, creating a certain gain.

3 The tax advantages which this plan sought to create for the taxpayer was the deduction of higher interest charges as current expenses (15.4% as opposed to 9.1%), and a characterization of the gain realized on retirement of the loan as a capital gain, which could then be offset against capital losses. It is claimed that this was proper tax planning aimed at obtaining the money at the lowest after tax cost, but the plan was challenged. Hence, this litigation.

Facts

4 On the basis of this Kiwi loan strategy Shell entered into two agreements. First, on May 10, 1988 Shell entered into Debenture Purchase Agreements with Amsterdam-Rotterdam Bank, Prudential Bank of America and Barclays Bank PLC (collectively, the “lenders”). The lenders agreed to purchase from Shell NZ$ debentures totalling NZ$150,000,000. The amount was due in five years, i.e., May 10, 1993. The purchase price was 102% of the principal, or NZ$153,000,000. The interest rate payable on the debentures was 15.4% per annum, payable semi-annually on November 10 and May 10 of each year. The net proceeds to Shell were NZ$151,875,000, after paying a commission to Goldman Sachs & Co. of NZ$1,125,000.

5 The second part of the plan involved a Master Forward Agreement with Sumitomo Bank Ltd. (Sumitomo). The Master Forward Agreement, referred to as a hedging transaction, provided three things. First, that on May 10, 1988 Sumitomo agreed to purchase NZ$151,875,000 from Shell in exchange for US$102,014,438. Second, it provided for Sumitomo to sell to Shell NZ$11,550,000 on each November 10 and May 10 in exchange for specified amounts of US$ until the principal was due on May 10, 1993.[FN1: <p>NZ$11,550,000 represented the interest charges payable to the lenders on those dates.</p>] Finally, the Agreement provided for Sumitomo to sell to Shell NZ$150,000,000 in exchange for US$79,590,000 on May 10, 1993. This last amount represented the principal payable to the lenders on that date.

6 The Trial Judge made a number of factual findings in connection with these transactions. He stated:

With respect to all of the bargains made on May 10, 1988 and related matters done subsequently I find: (i) that the parties were dealing with each other at arm's length; (ii) that Shell did not carry on business in New Zealand and had no intention of using the NZ$ in its business; (iii) that Shell was seeking US$ in the order of $102,000,000 to be used for its general corporate purposes; (iv) the decision to borrow the NZ$, the issuing of the debentures and the entering into the hedging transactions were based on Shell's expectation that in computing its income it could successfully deduct the interest paid under the debentures, that the US$21,165,000 gain would be accepted as being on capital account and that certain of its capital losses then existing could be set off against that gain; (v) that Shell would not have entered into the debenture agreements in the absence of the hedging transactions; (vi) that the rate of interest of 15.40% per annum in relation to the borrowing of NZ$ was a market established rate; (vii) that if Shell had simply borrowed US$102,000,000 at a market rate of interest, the rate would have been in the order of 9.1 % per annum which, of course, is substantially lower than 15,40% per annum; (viii) that Shell's overriding purpose in entering into the debenture agreements and the hedging transactions was to secure US$ at the lowest after tax cost attainable; (ix) that on May 10, 1988 Shell knew that on May 10, 1993 it would realize a gain of US$21,165,000 in respect of the debentures and hedging transactions; (x) that sham was not involved in respect of any of the bargains.[FN2: <p>Reasons for Judgment, at 7-8.</p>]

7 The gain of US $21,165,000 referred to represents the difference between the amount received by Shell for the NZ$150,000,000 and the cost in US$ needed to repurchase the NZ$ when the loan came due. This gain was due in part to the debenture agreement and in part to the hedging transactions entered into with Sumitomo.

8 Following its plan, Shell deducted interest expenses of 15.4% in each tax year between 1988 and 1993 and characterized the gain of US$21,165,000 as being on account of capital in 1993.

9 The Minister of National Revenue reassessed the taxpayer for the years 1992 and 1993, disallowing the deduction of interest beyond the market rate for a direct loan of US$. This amounted to a disallowance of $4,874,796 of the $15,519,491 interest deduction for the 1992 taxation year, and a disallowance of $1,675,643 of the $5,621,113 interest deduction for the 1993 taxation year. The basis for this disallowance was that the rate of 15.4% was not reasonable as required by paragraph 20(1)(c). Also, the Minister treated the $26,191,686 Canadian (US$21,165,000) claimed capital gain as on account of income. Shell appealed the reassessment and was successful at the Tax Court of Canada. That decision has been appealed to this Court.

Decision of the Tax Court Judge

10 The Tax Court Judge allowed the appeal of the taxpayer and permitted the deduction of the interest expenses as claimed. He disagreed with the Minister's argument that the two transactions, the debenture agreement and the hedging transaction, had to be viewed as one transaction for tax purposes. When viewed this way, the Minister argued, it is clear that Shell is really borrowing US$, and the determination of what constitutes a reasonable rate of interest should be judged on that basis. The Tax Court Judge stated:

With respect, I can only conclude that a merger of the kind postulated by counsel for the respondent belongs in the realm of legal fiction. Each of the contracts entered into between Shell on the one hand and Amsterdam, Prudential, Barclays on the other was separate and created the distinct legal obligations between Shell and each of the parties that are described in the agreements. The same can be said of the hedging transactions. And, in particular, these hedging transactions did not create a borrower-lender relationship with a consequent obligation to pay interest. I cannot accept that the legal effect of entering into the debenture agreements and the hedging transactions is to allow the relationships thereby created to be regarded as a matter of law to have been merged for the purpose of determining Shell's liability to tax under the Act in the manner argued on behalf of the respondent.[FN3: <p>Reasons, at 11.</p>]

11 The Tax Court Judge found that the money was certainly “borrowed money” and that it was clear to him that it was used for the purpose of earning income, as Shell required it for general corporate purposes. The money did not lose this quality by being first borrowed in NZ$ and then being converted into US$. On the basis of this conclusion, and having already determined that 15.40% was a market established rate for a NZ$ borrowing, the Tax Court Judge concluded that this was reasonable.

12 At trial, the Minister also advanced the argument that the interest rate was not reasonable for the purposes of section 67 of the Act. The Tax Court Judge found that, if the rate was reasonable for the purposes of paragraph 20(1)(c), it must also be reasonable for the purposes of section 67. In addition, the Tax Court Judge decided that the gain claimed in 1993 was indeed on account of capital.

Submissions of the Parties

13 The appellant submits that the Court must consider the economic realities of the situation in order to properly evaluate the deductibility of the interest expense. What was really happening here, it was said, was that Shell was borrowing US$. It had no use for NZ$ and only borrowed them because of the potential to avoid taxation that was available by doing so. Therefore, one could not say that the money was borrowed for the purposes of earning income. The interest was only deductible if the transactions are characterized as a US$ borrowing, and reasonable interest for a US$ borrowing was 9.1%.

14 The appellant also argues that subsection 245(1) applied, suggesting that the transactions entered into by Shell had the affect of artificially or unduly reducing its income for the years in question. Also, the Minister advanced the argument that the deductions were unreasonable according to section 67 of the Act. It was further contended that the gain in 1993 was not capital in nature but was on account of income.

15 The respondent submits that it was improper to assess tax liability based on the idea that it borrowed US$. There were two separate transactions, each creating distinct legal relationships. Shell borrowed NZ$ and the market rate was 15.40%. The market rate was by definition reasonable. It then purchased US$ and used them for general corporate purposes. Because the US$ were employed to earn income, the NZ$ loan proceeds must be considered to have been used for the purpose of earning income as well.

16 In my view, the essence of this case is whether or not the payments made by Shell came within the scope of paragraph 20(1)(c) so as to be deductible as interest payments. Given my conclusion with respect to paragraph 20(1)(c), therefore, it is unnecessary to deal with the other provisions discussed in argument. It will also be necessary, however, to deal with the issue of the 1993 gain. I shall first analyze paragraph 20(1)(c) and its applicability to these facts and then briefly consider the capital gains issue at the end of these Reasons.

The Law

17 The relevant parts of paragraph 20(1)(c) read as follows:

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

(c) an amount paid in the year or payable in respect of the year (depending upon the method regularly followed by the taxpayer in computing his 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.

18 The approach to the interpretation of the Income Tax Act is nowadays far removed from Lord Cairn's dictum that, in fiscal matters, form triumphs over substance.[FN4: <p><em>Partington v. Attorney General</em>(1869), L.R. 4 H.L. 100 (U.K. H.L.). See Stephen W. Bowman, “Interpretation of Tax Legislation: The Evolution of Purposive Analysis”,<em>Canadian Tax Journal</em>(1995), Vol. 43, No. 5, 1167.</p>] In Stubart Investments Ltd. v. R.[FN5: <p>[1984] 1 S.C.R. 536 (S.C.C.).</p>] , Estey J. outlined the trend toward purposive interpretation of taxing provisions. He states:

Gradually, the role of the tax statute in the community changed, as we have seen, and the application of strict construction to it receded. Courts today apply to this statute the plain meaning rule, but in a substantive sense so that if a taxpayer is within the spirit of the charge, he may be held liable.[FN6: <p><em>Ibid.</em>, at 578.</p>]

19 This is taken a step further in the Reasons for Judgment of Dickson C.J. in Bronfman Trust v. R.[FN7: <p>[1987] 1 S.C.R. 32 (S.C.C.).</p>] , where he writes:

Assessment of taxpayers' transactions with an eye to commercial and economic realities, rather than a juristic classification of form, may help to avoid the inequity of tax liability being dependent upon the taxpayer's sophistication at manipulating a sequence of events to achieve a patina of compliance with the apparent prerequisites for a tax deduction.[FN8: <p><em>Ibid</em>, at 53.</p>]

20 The Act has aims and purposes and, as Judges, it is our duty to give effect to those aims and purposes as reflected in the language of the legislation. We now use what has been called the words-in-total-context approach to statutory interpretation. In British Columbia Telephone Co. v. R.[FN9: <p>(1992), 92 D.T.C. 6129 (Fed. C.A.)</p>] MacGuigan J.A. concluded:

Indeed, even apart from authority, it should be obvious that words can never be considered apart from their context, since context imparts meaning to that which it surrounds.[FN10: <p><em>Ibid.</em>, at 6132.</p>]

21 It has often been said that, but for paragraph 20(1)(c), interest would not be deductible at all. The reason given is that the accumulation of capital is necessarily on capital account, and, therefore, the deduction of the interest expense would normally be disallowed by paragraph 18(1)(b). In Canada Safeway Ltd. v. Minister of National Revenue[FN11: <p>[1957] S.C.R. 717 (S.C.C.).</p>] the Supreme Court held the following:

It is important to remember that, in the absence of an express statutory allowance, interest payable on capital indebtedness is not deductible as an income expense. If a company has not the money capital to commence business, why should it be allowed to deduct the interest on borrowed money? The company setting up with its own contributed capital would, on such a principle, be entitled to interest on its capital before taxable income was reached, but the income statutes give no countenance to such a deduction.[FN12: <p><em>Ibid.</em>, at 727.</p>]

22 Our original income tax statute, The Income War Tax Act[FN14: <p>S.C. 1917, c. 28.</p>] , made no specific reference to the deductibility or non-deductibility of interest. Rather, it relied on the calculation of income as “net profit or gain.”[FN15: <p><em>Ibid.</em>, s. 3(1).</p>] Whether this precluded the deductibility of interest as a payment on account of capital or for any other reason is unknown, as there were no relevant cases decided under that Act.

23 In 1923, the Act was amended to deal specifically with the deduction of interest. The debate in the House of Commons indicated that the consensus was that interest ought to be deducted from income normally, but that the law as it stood failed to permit that deduction. Given the general principles of tax fairness, it would seem obvious that interest, so long as it is a business expense incurred to earn taxable income, is a legitimate expense. Because it is a legitimate expense, it was felt that it ought to be accounted for in order to gauge properly a taxpayer's liability for tax.[FN16: <p>In their review of the recommendations of the CBA-CICA Joint Committee on Taxation (Joint Committee on Taxation of the Canadian Bar Association and the Canadian Institute of Chartered Accountants, “Submissions to the Minister of Finance on the Issue of Deductibility of Interest,” in<em>Canadian Tax Reports</em>, Special Report no. 964, extra ed. (Don Mills, Ont.: CCH Canadian, August 1990)) Edgar and Arnold commented that the deduction of interest expenses was a legitimate deduction and could not be regarded as a tax expenditure (Tim Edgar and Brian J. Arnold, “Reflections on the Submission of the CBA-CICA Joint Committee on Taxation Concerning the Deductibility of Interest,”<em>Canadian Journal of Taxation</em>(1990), Vol. 38, No. 3, 847 at 878.) The Joint Committee recommended that the provisions for deducting interest in the Act be repealed and that the deductibility of interest should simply be dealt with under section 9 as relevant to computing income. As well, I note that some jurisdictions currently use this approach to the deductibility of interest expenses (e.g. Australia and Singapore. See Grant Richardson and Helen Anderson, “The Deductibility of Interest: An Asia-Pacific Comparison,”<em>The International Tax Journal</em>, Vol. 23, No. 3, 6).</p>]

24 The 1923 amendment allowed the following to be deducted from income:

(h) such reasonable rate of interest on borrowed capital used in the business to earn the income as the Minister in his discretion may allow notwithstanding the rate of interest payable by the taxpayer. To the extent that the interest payable by the taxpayer is in excess of the amount allowed by the Minister hereunder, it shall not be allowed as a deduction. The rate of interest allowed shall not in any case exceed the rate stipulated for in the bond, debenture, mortgage, note, agreement or other similar document, whether with or without security, by virtue of which the interest is payable.[FN17: <p>S.C. 1923, c. 52, s. 2..</p>]

So as long as the capital is used to earn income and the rate is thought to be reasonable by the Minister, interest payments were explicitly deductible. In defence of the reasonableness provision of the amendment, the Minister of Finance at the time, the Honourable W.S. Fielding, explained how a bond issue would be treated. He stated:

The ordinary, reasonable rate of interest would be allowed. But suppose the bonds were issued at a high rate of interest, and produced a premium, that practically is not the real rate of interest at all. I hope my honourable friend sees the point.[FN18: <p>Canada, House of Commons,<em>Debates</em>, June 27, 1923, 4494.</p>]

25 The interest deductibility provision was amended in 1948. The substance of the earlier paragraph remained the same,[FN19: <ul>S.C. 1948, c. 52. The new provision read as follows:<li><p>Notwithstanding any other provision in this Division, the following amounts may ... be deducted in computing the income of a taxpayer for a taxation year: ... (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 his income), pursuant to a legal obligation to pay interest on borrowed money used for the purpose of earning income from a business or property (other than property the income from which would be exempt), but, if the rate at which the interest was computed was unreasonably high, only such part of the amount so paid or payable as would have been paid or payable if the rate had been reasonable may be deducted.</p></li></ul>] but the new provision recognized different accounting methods and eliminated the need for the exercise of Ministerial discretion. Amendments to the provisions for deductibility of interest since that time have added nothing to the general paragraph, but have provided more detailed provisions for specific situations.[FN20: <p>See Arnold and Edgar, “Deductibility of Interest Expense”,<em>Canadian Tax Journal</em>(1995), Vol. 43, No. 5, 1216.</p>]

26 The provision, as it stands today, is in substance similar to the 1948 provision. It may be broken down into several conditions that a borrower must satisfy in order to be able to deduct amounts claimed as interest. While one could say that there were six or even more conditions, I prefer to think that there are four main conditions, some of which comprise more than one component.[FN21: <p>Professor Krishna,<em>supra</em>, note 13, similarly identifies the first three conditions but does not consider the reasonableness criterion as part of the substantive aspect of deductibility.</p>] First, the amount must be paid in the year (or be payable in the year, depending on which method of accounting the taxpayer uses). Second, it must be paid pursuant to a legal obligation to pay interest on borrowed money. Third, the money must be used for the purpose of earning income from a business or property (not including exempt income). Fourth, the rate of interest must be reasonable. I shall now expand upon the meaning of the four conditions in turn.

1. Paid in the Year

27 The first condition, that the interest be paid or payable in the year, reflects the idea that, in order to qualify for a deduction, the expense must have been incurred in the taxation year. The paragraph recognizes that different taxpayers employ different methods of accounting (i.e., cash basis or accrual basis).

2. Legal Obligation to Pay Interest on Borrowed Money

28 The second condition involves three components. First, the amount must be paid pursuant to a legal obligation to pay. In other words, there is no such thing as a deduction for money paid voluntarily; there must be a legally recognizable duty to pay.

29 Second, the payment must be a payment of interest. A payment that may look like interest but is in fact a distribution of profits, or a payment on account of principal, does not qualify. The Supreme Court, in Saskatchewan (Attorney General) v. Canada (Attorney General)[FN22: <p>[1947] S.C.R. 394 (S.C.C.).</p>] , defined “interest” as “the return or consideration or compensation for the use or retention by one person of a sum of money, belonging to, in a colloquial sense, or owed to, another.”[FN23: <p><em>Ibid.</em>, at 411.</p>] This definition has been narrowed by the addition of the requirement that the payment accrue on a day to day basis.[FN24: <p><em>Ontario (Attorney General) v. Barfried Enterprises Ltd.</em>, [1963] S.C.R. 570 (S.C.C.).</p>] Moreover, interest must be calculated with reference to a principal sum. This last criterion was determined in Balaji Apartments Ltd. v. Manufacturers Life Insurance Co.[FN25: <p>(1979), 100 D.L.R. (3d) 695 (Ont. H.C.).</p>] In that case the terms of a mortgage called for 9% interest on the principal plus 1% of the gross rental revenue in excess of $135,000. The payments of 1% of the revenue were found not to be interest because the payment was “not a percentage of, or in any way related to, the principal sum.”[FN26: <p><em>Ibid.</em>, at 697.</p>] In Miller v. Minister of National Revenue[FN27: <p>(1985), 85 D.T.C. 5354 (Fed. T.D.)</p>] Reed J. made the following comment about interest:

It is common ground that the Income Tax Act does not define interest and that the various sections dealing with interest therein(12(1)(c); 110.1(1); 110.1(2); 110.1(3)(ff), either deeming, or excluding certain amounts for certain purposes as interest are of little assistance. One must look to the general principles of interpretation, dictionary definitions and the jurisprudence. In this regard the meaning of the word “interest” in ordinary parlance is significant.[FN28: <p><em>Ibid.</em>, at 5356.</p>]

30 The determination of what is interest is always a question to be ultimately decided by the Court. Something is not interest merely because the parties agree to call it interest. In Minister of National Revenue v. Groulx[FN29: <p>(1966), 66 D.T.C. 5126 (Can. Ex. Ct.); aff'd.(1967), [1968] S.C.R. 6 (S.C.C.).</p>] the taxpayer had sold a piece of land and accepted a price that was above market value. Part of the purchase price was to be paid immediately but the balance was due in annual instalments “interest free.” By characterizing the entire purchase price as not including interest on the outstanding balance the taxpayer was seeking to avoid paying tax on the interest portion, because at that time capital gains on the disposition of the land were tax-free. The Supreme Court of Canada affirmed the decision of Justice Kierney of the Exchequer Court, who held that the purchase price included a capitalization of interest payments that ought properly to be included in income.

31 The third component of this second condition is that the payment must be made on account of borrowed money. The exact wording of the paragraph was not capable of accommodating the types of financial arrangements that taxpayers were able to devise to meet their commercial needs. Subparagraph 20(1)(c)(ii) was enacted[FN30: <p>S.C. 1950, c. 40, s.5.</p>] specifically to deal with a situation where interest was being paid not on borrowed money, but on the unpaid purchase price of property. As well, paragraph 20(1)(d) deals with compound interest, which is interest on interest, and not interest on borrowed money.

3. Purpose of Earning Income

32 The third element is that the money must be used for the purpose of earning income. This expresses the fundamental principle of tax justice that unless the expense is incurred for an income earning purpose then it cannot be deductible. Therefore, to the extent that an expense is incurred for personal reasons or for earning income that is exempt from taxation the deduction cannot be allowed. One example is 74712 Alberta Ltd. v. Minister of National Revenue,[FN31: <p>(1997), 97 D.T.C. 5126 (Fed. C.A.)</p>] where the interest deduction was disallowed because the use to which the money was put could not have earned income for the business. In that case, the taxpayer was part of a group of companies and, in the course of the group's reorganization, it guaranteed loans made to other members of the group. When the guarantee was called in, the taxpayer was forced to borrow funds in order to satisfy it. The Court held that the interest could not be deductible because the purpose for extending the guarantee was not to earn income. Justice Robertson made the important point that “purpose” and “use” were terms that had to be evaluated in an objective sense and not subjectively.[FN32: <p><em>Ibid.</em>, at 5135.</p>] Even though subjectively the taxpayer in that case may have been acting for a business purpose, that interest was found to be non-deductible because the satisfaction of the guarantee would never earn income for the taxpayer.

33 In Bronfman Trust supra, the Supreme Court established that what is necessary to satisfy this third condition is a current, direct, eligible use for the money. In that case the taxpayer trust wanted to make a capital distribution to the beneficiary of the trust. This was clearly a non-eligible use, as the disposition could not be for the purposes of earning income. The trustees, however, felt that it was an inopportune time to dispose of the income-producing assets of the trust and, therefore, borrowed the money in order to make the distribution to the beneficiary. The trustees sought to deduct the interest expense on the basis that it was necessary to borrow the money in order to maintain the income-producing assets, and that, therefore, the money was used indirectly to earn income.

34 Dickson C.J. disallowed the deduction, explaining:

The interest deduction provision requires not only a characterization of the use of borrowed funds, but also a characterization of “purpose”. Eligibility for the deduction is contingent on the use of borrowed money for the purpose of earning income. It is well established in the jurisprudence, however, that it is not the purpose of the borrowing itself which is relevant. What is relevant, rather is the taxpayer's purpose in using the borrowed money in a particular manner ... Consequently, the focus of the inquiry must be centred on the use to which the taxpayer put the borrowed funds.[FN33: <p><em>Bronfman Trust</em>supra, note 7, at 46.</p>]

The taxpayer, of course, has a right to spend money in ways which cannot reasonably be expected to generate taxable income but if the taxpayer chooses to do so, he or she cannot expect any advantageous treatment by the tax assessor. In my view, the text of the Act requires tracing the use of borrowed funds to a specific eligible use, its obviously restricted purpose being the encouragement of taxpayers to augment their income-producing potential. This, in my view, precludes the allowance of a deduction for interest paid on borrowed funds which indirectly preserve income-earning property but which are not directly “used for the purpose of earning income from ... property.”[FN34: <p><em>Ibid.</em>, at 53-54.</p>]

35 Once the use has been identified, the question becomes one of whether the use is for an eligible purpose. In Mark Resources Inc. v. R.[FN37: <p>(1993), 93 D.T.C. 1004 (T.C.C.)</p>] , Bowman J.T.C.C. dealt with the question of purpose under paragraph 20(1)(c). In that case, the taxpayer had borrowed money in Canada and transferred the capital to its American affiliate. The affiliate used the money to purchase a term deposit that earned an amount of income identical to its accumulated business losses. The income was imported back into Canada as a tax free dividend. The effect of the transactions was an importation of the business losses. Bowman J.T.C.C. disallowed the deduction on the ground that the money was not used for the purpose of earning income. He explained:

Theoretically one might, in a connected series of events leading to a predetermined conclusion, postulate as to the purpose of each event in the sequence the achievement of the result that immediately follows but in determining the “purpose” of the use of borrowed funds within the meaning of paragraph 20(1)(c) the court is faced with practical considerations with which the pure theorist is not concerned. That purpose - and it is a practical and real one, and in no way remote, fanciful or indirect - is the importation of the losses from the U.S.

It is true that the economic result, if all of the elements of the plan work, is a net gain to the appellant, but this type of gain is not from the production of income but from a reduction of taxes otherwise payable in Canada. I am cognizant of the fact that the dividends, although deductible in computing taxable income, are nonetheless income. It is, however, this feature of our Canadian tax system whereby such dividends are deductible in computing taxable income that gives to the plan its apparent economic viability.[FN38: <p><em>Ibid.</em>, at 1012.</p>]

36 The Mark Resources Inc. approach was applied in Canwest Broadcasting Ltd. v. R.[FN40: <p>(1995), 96 D.T.C. 1375 (T.C.C.)</p>] . The facts in the two cases were similar. In Canwest Broadcasting Ltd., the taxpayer had incurred large interest expenses in an attempt to take advantage of losses accumulated by a non-related company. McArthur J.T.C.C., disallowed the deduction of the interest charges on the ground that the purpose behind the series of transactions was a reduction of taxes and that this did not constitute an eligible use. He stated:

I find that the Court must look at the commercial, practical and economic reality of the taxpayer's transactions, and not permit form to override substance. The Court must ensure that the “purpose” which is used for a paragraph 20(1)(c) analysis is one that represents what the taxpayer's real intentions are, and not what he or she makes them appear to look. In Bronfman Trust, the “real purpose” was the distribution of capital. In the present case, the “real purpose”, as demonstrated by the evidence was tax savings.[FN41: <p><em>Ibid.</em>, at 1383.</p>]

37 The same approach was adopted in Robitaille c. R.[FN42: <p>(1997), 97 D.T.C. 1286 (T.C.C.)</p>] . In that case, Dussault J.T.C.C.., commented on the necessity of an eligible use for the borrowed money. He stated:

Secondly, for the purpose of the deduction provided for in paragraph 20(1)c) of the Act, it has also been established in [ Bronfman Trust] that what should be considered is not the purpose of the borrowing itself but rather the purpose for which the borrowed money was used. In fact, as Judge Bowman of this Court suggested in Mark Resources Inc., supra, to the extent that, prima facie, the purpose of the borrowing and that for which the funds were used are identical, the distinction is not meaningful. However, as he pointed out, focus must be had not on the direct and immediate result of the use to which the funds were put but rather, in a real and practical manner, on the ultimate economic objectives sought by the transactions. Thus it seems clear that the analysis should not be restricted to the consideration of each of the transactions taken individually while ignoring the cause-effect relationship that may exist between them.[FN43: <p><em>Ibid.</em>, at 1291.</p>]

38 In my view, Mark Resources Inc. and Bronfman Trust both express the same philosophical approach to the interpretation and application of taxing statutes. While the direct and current use doctrine does not seem, at first glance, to be entirely consistent with the practice of determining the overriding purpose for the borrowing, in both instances the Court's overarching concern was the avoidance of inequities that can arise through the formalistic application of the Act. Dickson C.J. was concerned about two things. His major concern was that a reading of paragraph 20(1)(c), which allowed the deduction of interest on money borrowed for an indirect eligible purpose, would advantage anyone who had assets that he or she wished to preserve. That taxpayer would be able to claim the interest deduction despite the fact that the money was borrowed for a purely personal reason, so long as they could justify the borrowing on the basis that it allowed them to preserve assets that earned income. This would be an enormous tax advantage to the wealthy taxpayer, and would, therefore, be inequitable.

39 Dickson C.J. also was concerned with the degree to which a sophisticated taxpayer could manipulate his or her financial transactions to achieve a “patina of compliance”. This concern recognizes that the analysis of individual transactions is not always a reliable barometer of the taxpayer's true economic situation. In recognizing that, it acknowledges that what the Act is concerned with at its heart is not really particular transactions, but how those transactions affect a taxpayer's economic situation.

40 This was precisely Judge Bowman's concern in the Mark Resources Inc. case; that is, allowing a deduction of interest where the whole substance of the operation was aimed at the avoidance of taxation. He thought that it would be unfair to subsidize taxpayers who were able to engineer such a result by allowing the deduction. In that case, the taxpayer was in the same economic situation before the transaction as afterward. It spent interest in Canada to earn interest in the U.S. where that income would be sheltered. A taxpayer similarly situated to Mark Resources Inc., but who had not engaged in the tax avoidance measure, would be taxed differently. This is the result that Dickson C.J. decried in Bronfman Trust.

4. Reasonable

41 Fourth and finally, the payments of interest must also be reasonable. The difficulty here is obviously how the term “reasonable” is to be interpreted. Two possibilities present themselves. The Court may ask what is a reasonable rate of interest for the lender to charge. Or, the Court may ask itself what is a reasonable rate of interest for the borrower to pay. In my view, since the provision is about the reasonableness of the deduction of the interest payments claimed by the borrower, the appropriate question is the latter. It should be pointed out that, in the majority of situations, the answer to both of these questions would probably be the same.

42 Originally, the Minister of Finance, who sponsored the enactment of this provision, Mr. Fielding, was worried about rates of interest that were “practically not the real rate of interest at all.” He retained a discretion to decide whether a rate was reasonable. The use of a reasonableness provision in the current subparagraph serves the same function. It is properly viewed as a kind of anti-avoidance provision. It is there to permit the disallowance of a deduction where the form of a taxpayer's transaction does not reflect the economic realities of the situation.

43 Ordinarily the market rate of interest will be a reasonable rate of interest, but there is nothing sacred about this statement. At times a higher rate might be appropriate for a particular taxpayer in a particular circumstance. The opposite could also be true. In every case, in order to determine the reasonableness of the interest rate, the Court ought to concern itself with the economic realities, as suggested by Dickson C.J.

44 Ultimately, paragraph 20(1)(c) can be viewed as a self-contained taxing statute in miniature. It is composed of an accounting period and basic principles of deductibility (which mirror basic principles of liability for taxation), and it identifies a basis on which transactions will be recognized for income tax purposes, and contains its own avoidance provision. I shall now apply these principles to the facts of this case.

Analysis

45 Given the facts of this case, an analysis of the four conditions of paragraph 20(1)(c) clearly reveals that the 15.4% interest rate cannot be deductible. I find that the claimed expense fails to comply with three of the four conditions required -- it is not interest, it is not used for the purpose of earning income, and it is not reasonable.

46 The first condition is clearly complied with -- the amount claimed was paid in the taxation years. The debentures issued by Shell obligated it to pay interest semi-annually. This interest was paid on each May 10th and November 10th while the debentures were outstanding in accordance with the contract.

47 The second condition, however, is not met. It is true that the payments were made pursuant to a legal obligation; Shell did not volunteer the payments, nor did it pay 15.4% interest where a lesser amount was legally owing. It is also true that the amounts were paid on borrowed money, and we do not have to concern ourselves with problems that might arise where what is borrowed is not money but some other kind of asset. However, the amounts that were paid, in my view, were not entirely interest; a portion of those payments were really principal. Let me explain.

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. The evidence heard at trial and accepted in the literature is that, in reality, there is no discrepancy between interest rates for convertible currencies. This is so because the interest rate parity theory dictates that the differential between the forward and spot exchange rates of two currencies equals the differential between the interest rates of those two currencies. As a result, the rate of interest on the foreign currency, if hedged against the fluctuation of the currencies, is equal to the domestic rate of interest. David Broadhurst C.A. explained the effect of this theorem in this way:

...according to the interest rate parity theory, a foreign exchange forward rate merely expresses the difference between interest rates prevailing in different currency markets for interest rate instruments of comparable risk having the same term as that for which the forward rate applies. Accordingly, relative interest rates and forward exchange rates are aspects of the same phenomenon. Fiscal advantage is gained by those who can successfully uncouple linked financial phenomenon so that the elements can be taxed more favourably as separate transactions than as a combined transaction.

Although the equivalence of interest rates and foreign exchange forward rates is not a legal principle, the courts will eventually understand the phenomenon and their understanding thereof will undoubtedly colour their appreciation of the essential characteristics of a variety of foreign exchange hedging transactions.[FN44: <p>David G. Broadhurst, “Tax Considerations for Hedging Transactions” in<em>Taxation of Financial Transactions</em>(Insight Press: Mississauga, Ontario) 1991, at 6-9.</p>]

50 The question of what is the real interest rate must take into account the workings of international financial markets. The words of Stephen Ruby, speaking of a hypothetical Kiwi loan, reflect the reality of the situation. He opined:

...if the Department viewed the Kiwi structure as being in effect a synthesized Canadian dollar loan for a principal amount equal to the Canadian dollar value of the Kiwi borrowing determined according to the spot rate of exchange at the time of the borrowing with interest payable at applicable Canadian dollar interest rates, then a portion of each interest payment would be viewed as being on account of principal and not deductible.[FN45: <p>Stephen S. Ruby, “Hedging Transactions” in<em>Taxation of Financial Transactions</em>(Insight Press: Mississauga, Ontario) 1991, at VII-33.</p>]

51 The portion of interest paid above 9.1% is not interest for the purposes of paragraph 20(1)(c). It was not compensation for the use of borrowed money. Essentially it was the borrowed money. The higher interest rate coupled with the discounted forward rate created a blended payment of interest and principal. Shell would not have paid the 15.40% interest if not for the certainty that a gain would be realized at the end of the day.

52 In coming to this conclusion, I need not be constrained by contract theory, as was the Tax Court Judge, who found that the parties could not have reached a consensus ad idem with respect to the characterization of periodic payments in that the parties did not agree that the interest payments were part principal and part interest. The important consideration is not what the parties agree to, nor what their intent is. What the Court must consider are the practical realities of the situation. Just as in Groulx, where the Court was not content with the legal form of the payments or the agreement of the parties, and turned its mind to the substance of the transaction, in the case at bar I cannot help but conclude that the decision to pay 15.4% interest was done for consideration other than the use of the borrowed money. To the extent that the consideration was for something other than that use of the money, the payments were not interest. The second condition, therefore, has not been met.

53 Neither has the third condition been complied with. Looking realistically at the substance of the situation, there was no use and purpose other than the avoidance of taxation for borrowing NZ$. It is true that Shell did require US$ financing independent of any tax avoidance considerations, so that there are two potential uses at work here. One would be eligible, namely the acquisition of working capital for the business, because the borrowed US$ was put to that use. But the NZ$ was borrowed primarily to avoid tax, as well as to get the US$. Dickson C.J. mentioned the possibility of multiple uses of borrowed money in Bronfman Trust:

The statutory deduction thus requires a characterization of the use of borrowed money as between the eligible use of earning non-exempt income from a business or property and a variety of possible ineligible uses. The onus is on the taxpayer to trace the borrowed funds to an identifiable use which triggers the deduction. Therefore, if the taxpayer commingles funds used for a variety of purposes only some of which are eligible he or she may be unable to claim the deduction.[FN47: <p><em>Bronfman Trust</em>supra, note 7, at 45 - 46.</p>]

54 It is clear that money spent to reduce tax liability is not deductible. In Mark Resources Inc., Bowman J.T.C.C. explicitly found that the avoidance of taxation was not an eligible use. Also, though spoken in another context, the words of Hugessen J.A. in Moloney v. R.[FN48: <p>(1992), 92 D.T.C. 6570 (Fed. C.A.)</p>] are helpful, where he states:

While it is trite law that a taxpayer may so arrange his business as to attract the least possible tax, it is equally clear in our view that the reduction of his own tax cannot by itself be a taxpayer's business for the purpose of the Income Tax Act. To put the matter another way, for an activity to qualify as a “business” the expenses of which are deductible under paragraph 18(1)(a), it must not only be one engaged in by the taxpayer with a reasonable expectation of profit, but that profit must be anticipated to flow from the activity itself rather than exclusively from the provisions of the taxing statute.[FN49: <p><em>Ibid.</em>, at 6570 (footnotes omitted).</p>]

55 In the present case the facts are unique. We cannot ignore the fact that Shell had financial requirements which the borrowed funds ultimately satisfied. But what gives the NZ$ borrowing its “apparent economic viability” is the potential to limit Shell's tax liability. I am not suggesting that tax considerations are not legitimate business considerations; what is in issue is whether such considerations, where they are the predominant ones, should be subsidized through the Income Tax Act. The true or real purpose, the ultimate economic objective, realized by borrowing NZ$ and paying the extra percentage was the reduction of taxation, and this is not an eligible use.

56 The fourth condition has not been complied with. As I said, ordinarily a reasonable rate of interest for the lender to charge will be a reasonable rate of interest for the borrower to pay. However, in this case the two rates do not coincide. It is eminently reasonable for the lenders in this case to charge 15.4% interest, as that is a market established rate in New Zealand. It is not, however, reasonable for Shell to pay that interest. The economic realities make it clear that the only eligible use for the money is in terms of the US$. The reasonableness of the deduction must be judged on that basis. The borrowing of NZ$ in and of themselves is not an eligible use and therefore cannot be an appropriate bench-mark. Reasonable interest is to be determined with reference to a direct borrowing of US$. Shell should be in the same position as a taxpayer who borrowed US$ directly. That interest rate was then 9.1%.

57 I am not persuaded by the Respondent's argument that it was eminently reasonable for a taxpayer to agree to pay higher interest when the after-tax cost of the financing would be more advantageous. The very question we are trying to answer is whether or not the amounts are in fact deductible so as to reduce the after-tax cost of financing. To say that allowing the deduction is advantageous to the taxpayer, and therefore the amount should be deductible, simply begs the question. The higher interest rate is not reasonable; therefore, the after-tax cost of financing is not, in fact, what the taxpayer hoped it would be.

58 As well, since the reasonableness provision is a type of anti-avoidance tool, it might be useful to assess the transaction with an eye to whether there was an artificial reduction of taxation. It is clear in this case that what Shell was trying to do was to create the illusion of high current expenses while at the same time converting those expenses into a gain which it hoped to offset against capital losses. Shell hoped to deduct interest of 15.4% when in reality it has only paid interest of 9.1%. The higher interest is “practically not the real rate of interest at all,” as Mr. Fielding noted with respect to the example of a bond issued at a premium. While it was difficult for Mr. Fielding's colleagues in the House of Commons in the 1920's to imagine why anyone would pay higher interest when they could pay lower interest, today, with the sophistication of exotic debt obligations and other financial instruments we have no difficulty understanding the possible advantages to a taxpayer. To the extent that the interest paid on the NZ$ exceeds the reasonable rate of 9.1%, it is, therefore, not deductible.

Capital Gain Issue

59 Having determined that the payments of interest in excess of 9.1% are not deductible under paragraph 20(1)(c) it is necessary to decide the issue of the gain realized on the retirement of the loan. There were in fact two gains realized on May 10, 1993 by Shell, totalling US$21,165,000. One part of that gain represents the difference between the spot rate of exchange for converting US$ into NZ$ (.5438) and the forward rate agreed upon between Shell and Sumitomo (.5306) in the Master Forward Agreement. This represents a gain of US$1,980,000, which is attributable to the Master Forward Agreement. The balance of the gain is attributable to the debentures.

60 Respecting these gains the Tax Court Judge was correct. The determinative fact is the nature of the transaction itself. For example in Alberta Gas Trunk Line Co. v. Minister of National Revenue[FN50: <p>(1971), [1972] S.C.R. 498 (S.C.C.).</p>] the taxpayer borrowed US$ to build a pipeline at a time when the CDN$ was at a premium versus the US$. When the US$ gained in value vis-a-vis the CDN$ the taxpayer tried to deduct the loss from income. Martland J. stated:

But, in any event, whatever such losses may prove to be, the borrowing was a borrowing of capital, for the construction of capital assets.

If the appellant, in due course, is required to pay more Canadian dollars to liquidate its capital debt of $67,000,000 (U.S.) than the number of Canadian dollars realized on the sale of its U.S. pay securities, the difference between the two amounts will represent a loss on capital account, and it cannot be deducted from income for tax purposes.[FN51: <p><em>Ibid.</em>, at 505.</p>]

61 Similarly, in Columbia Records of Canada Ltd. v. Minister of National Revenue[FN52: <p>[1971] C.T.C. 839 (Fed. T.D.)</p>] the taxpayer borrowed substantial sums of US$ from its American parent in the way of working capital. Due to a decline in the value of the CDN$ Columbia Records suffered losses on the repayment of these amounts. The Court held that the losses did not arise in the ordinary course of the appellant's trading operations but were incurred in obtaining working capital, and the transactions brought an enduring benefit to the business. For these reasons the transactions were determined to be of a capital nature and the losses could not be deducted from income.

62 In this case the acquisition of the NZ$150,000,000 provided the taxpayer with working capital for the business. I am not persuaded by the argument put forward by the appellant that the gain must be income because it was guaranteed to occur. The important point is not how certain the gain was, but why the capital was acquired in the first place. The borrowing of a fixed sum of money for a period of five years will, in the absence of extraordinary circumstances, normally is a capital transaction. The gain, therefore, must be on account of capital. This determination is valid both for the gain on the debentures and the gain realized on the Master Forward Agreement.

63 Counsel for the Minister indicated that, if they were successful on the interest issue, they would make adjustments to the total of this gain so as to avoid double taxation on those amounts.

Conclusion

64 There is no doubt that Shell has achieved a “patina of compliance” in arranging its financing as it did. However, form does not always trump substance. It is possible to strike a balance between the two. In this case Shell has achieved the substance of a US$ borrowing in the form of a NZ$ debenture. If the tax system is going to avoid the inequities spoken of by Dickson C.J.C., where a taxpayer's sophistication and financial resources determine the extent of his or her tax liability, then the taxpayer who, in substance, borrows US$, should be taxed on that basis. I would allow the appeal with costs, set aside the decision of the Tax Court Judge, and refer the matter back to the Minister to be reassessed in accordance with these reasons.

Stone J.A.:

1 I am in agreement with the reasons for judgment of Linden J.A., that the facts of this case are not such as to bring the full amount of interest paid at the rate of 15.4% on the NZ$ loans within paragraph 20(1)(c) of the Income Tax Act.

2 In the event that I am wrong with respect to the paragraph 20(1)(c) issue, I wish to address briefly the Crown's argument, which was fully aired at the hearing of this appeal, that the transaction falls within subsection 245(1) of the Act as it stood on May 10, 1988, the date on which it was entered into. That subsection read:

245(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.

3 In Fording Coal Ltd. v. R. (1995), [1996] 1 F.C. 518 (Fed. C.A.)and Central Supply Co. (1972) Ltd. v. R., [1997] 3 F.C. 674 (Fed. C.A.), this Court outlined three factors to be considered in determining whether the income of a taxpayer has been unduly or artificially reduced contrary to subsection 245(1). Linden J.A., for the majority, summarized these considerations in Central Supply Co. supra, at page 691, as follows:

...first, whether the deduction sought is contrary to the object and spirit of the provision in the Act, second, whether the deduction is based on a “transaction or arrangement which is not in accordance with normal business practice”, and third, whether there was a bona fide business purpose for the transaction.

Finally, I recognize that the approach which I am advocating may entail a certain element of discretion in the application of subsection 245(1). This cannot be entirely avoided for the assessment of object and spirit, consistency with ordinary business practice and evaluation of business purpose must, of necessity, proceed on a case-by-case basis. This case-by-case approach is often criticized for its lack of certainty, particularly by those whose brilliant tax structures are found by courts to be unlawful. As one American commentator pointed out, however, some uncertainty is “an inevitable part of modern taxing systems”.

[footnote omitted]

4 On the facts of this case, I am of the view that the provisions of subsection 245(1) are inapplicable. First, I am unable to view the respondent's deduction of the interest as contrary to the object and spirit of paragraph 20(1)(c), which is to encourage the accumulation of capital with which to earn income.[FN53: <p><em>Bronfman Trust v. R.</em>, [1987] 1 S.C.R. 32 (S.C.C.), per Dickson C.J., at p. 45;<em>Tennant v. R.</em>, [1996] 1 S.C.R. 305 (S.C.C.), per Iacobucci J., at pp. 310-11.</p>] Paragraph 20(1)(c) permits taxpayers to deduct interest payments when the borrowed funds are used to earn income from a business or property, which is precisely what the respondent did in the present case.

5 Second, I do not view the respondent's borrowing as not according with normal commercial practice. In choosing to borrow the funds in NZ$ rather than US$ the respondent took into account the overall tax impact of the transaction, and this is a common business concern. More significantly, the borrowed funds when converted to US$ were needed by the respondent for general corporate purposes. The learned Tax Court Judge made a finding of fact to that effect, and it is not contended that his finding is erroneous.

6 Third, in my opinion the respondent's borrowing possessed a bona fide business purpose. It seems to me to make no difference, for the purpose of subsection 245(1), that the scheme had as

its objective a tax saving, when it is also clear that the respondent's aim in acquiring the NZ$ was to secure US$ capital for a legitimate business purpose. Indeed, as was stated by McLachlin J., concurring in Hickman Motors Ltd. v. R., [1997] 2 S.C.R. 336 (S.C.C.)at pages 345-46:

The fact that the directors of the taxpayer may have intended to obtain a tax saving by acquiring the asset is irrelevant. It is a fundamental principle of tax law that “[e]very 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”: Inland Revenue Commissioners v. Westminster (Duke of), [1936] A.C. 1 (H.L.), at p. 19, per Lord Tomlin. As Wilson J. put it in Stubart Investments Limited v. R., [1984] 1 S.C.R. 536at p. 540, “[a] transaction may be effectual and not in any sense a sham (as in this case) but may have no business purpose other than the tax purpose.”

4 I would dispose of this appeal in the manner proposed by Linden J.A.