Shell Canada Ltd. v. R., 97 D.T.C. 395, [1997] 3 C.T.C. 2238

Christie, A.C.J.T.C.:

1 What is in issue in these appeals is whether in reassessing Shell Canada Limited (“Shell”) regarding its liability to income tax the Minister of National Revenue (“the Minister”) erred

• (i) in disallowing $4,874,796 of the $15,519,491 interest deduction claimed by Shell in respect of its 1992 taxation year;

• (ii) in disallowing $1,675,643 of the $5,621,113 interest deduction claimed by Shell in respect of its 1993 taxation year; and

• (iii) in treating a claimed capital gain of $26,191,686 in respect of Shell's 1993 taxation year as having been on income account.

2 Briefly, these appeals involve the fiscal effect of the borrowing by Shell of funds in a foreign currency. As just indicated the issues fall into two categories: one, the deductibility of interest on that borrowing and two, the treatment of what was gained when the amount borrowed was retired. It is obvious that the interest rate under the loan agreements in the foreign currency is substantially higher than would have been payable under a similar loan in United States dollars (“US$”).[FN1: <p>The symbol US$ relates to both the singular and the plural. The same applies to NZ$ and CDN$. In these reasons where no symbol is related to currency the currency is Canadian.</p>] It was those dollars that were required by Shell in its business. The matter is complicated by the fact that the initial borrowing was in New Zealand dollars (“NZ$”) which were immediately converted to US$ and the fact that the appellant is a Canadian corporation which must report its income in Canadian dollars (“CDN$”). A second complicating factor is that since the appellant's obligations to the lenders were in NZ$ it entered into a foreign exchange contract with respect to both the semi-annual payments required on the loan and the amount required for the ultimate repayment of the loan. What follows explains this in some detail.

3 On May 10, 1988 Shell entered into a two-part financing arrangement. First it entered into Debenture Purchase Agreements with Amsterdam-Rotterdam Bank N.V. (“Amsterdam”), Prudential Bank of America (“Prudential”) and Barclays Bank PLC (“Barclays”) (“the lenders”) whereby each agreed to purchase from Shell a NZ$ debenture in these amounts: Amsterdam $67,000,000, Prudential $50,000,000, Barclays $33,000,000 for a total principal amount of $150,000,000. That amount was due in five years, i.e. May 10, 1993 and was paid accordingly. The total purchase price of the debentures was NZ$153,000,000 or 102% of the principal amount. The rate of interest on each debenture was 15.40% per annum payable semi-annually on November 10 and May 10 of each year commencing November 10, 1988 and ending May 10, 1993. The interest was paid. A commission of NZ$1,125,000 was paid to Goldman, Sachs & Co. as broker leaving NZ$151,875,000 net to Shell.

4 Under these agreements debentures in the principal amount were to be delivered by Shell to the lenders in New York City on or about 10 a.m. (New York City time) on May 10, 1988 against payment of the purchase price being made in NZ$ by the lenders depositing that price by 10 a.m. (Wellington, New Zealand time) in funds immediately available to Shell in an account in New Zealand designated by Shell.

5 Second, Shell also entered into a Master Forward Agreement with Sumitomo Bank Limited (“Sumitomo”) under which

• (i) Shell agreed to initial forward transactions whereby it would sell NZ$151,875,000 (the net proceeds to it under the debenture agreements) to Sumitomo and the latter agreed to sell US$102,014,438 to Shell; and

• (ii) Shell agreed to deliver on the same day NZ$151,875,000 by wire transfer to the principal office of the Bank of New Zealand, Wellington, for the account of Sumitomo and Sumitomo agreed to deliver US$102,014,438 for the account of Shell in accordance with Schedule “A” to the agreement. It reads:

  Schedule ‘A’ Payments to shell Canada Limited in U.S. Dollans in New York City

  Fedwire Payment - (Through The Federal Reserve Bank)

  PAY THROUGH	THE CHASE MANHATTAN
  	BANK N.A.,
  	NEW YORK FEDWIRE
  	ROUTING NUMBER: 0210-0002-1
  FOR ACCOUNT	: #001-1-146305
  	BANK OF MONTREAL, I.P.S.C.,
  	MONTREAL
  FOR TRANSFER TO	: CALGARY MAIN OFFICE
  FOR CREDIT ACCOUNT	: 00109-4604-211 SHELL CANADA LIMITED

• (iii) Shell agreed in respect of 10 subsequent forward transactions (which were included in the Master Forward Agreement) to deliver to Sumitomo on designated dates stipulated amounts in US$ to the account of Sumitomo and Sumitomo agreed regarding the same transactions to deliver on those specified dates amounts in NZ$ to the account of Shell. These subsequent transactions may be summarized as follows:

  Summary of Forward Transactions Except the Initial Forward Transactions

  Dates	Shell Received from Sumitomo NZ$	Shell Paid to Sumitomo US$
  November 10, 1988	11,550,000	7,450,905
  May 10, 1989	11,550,000	7,225,680
  November 10, 1989	11,550,000	7,051,275
  May 10, 1990	11,550,000	6,875,715
  November 10, 1990	11,550,000	6,715,170
  May 10, 1991	11,550,000	6,554,625
  November 10, 1991	11,550,000	6,448,365
  May 10, 1992	11,550,000	6,340,950
  November 10, 1992	11,550,000	6,234,690
  May 10, 1993	11,550,000	6,128,430
  May 10, 1993	150,000,000	79,590,000

6 The first ten amounts were to cover the 10 semi-annual payments Shell was to make to the lenders between November 10, 1989 and May 10, 1993. The last amount was to cover the repayment of the NZ$150,000,000 on the retirement of the debentures at the end of the five-year period on May 10, 1993. Each of these transactions was consummated. The purpose of the initial and subsequent forward foreign exchange transactions that constitute the Master Forward Agreement (“the hedging transactions”) was to hedge[FN2: <p>“<em>Hedge/Hedging</em>strategy used to offset investment risk. A perfect hedge is one eliminating the possibility of future gain or loss”:<em>Barron's Finance and Investment Handbook</em>at p. 292.</p>] Shell's liability in respect of the NZ$ debentures.

• 1. Shell receives NZ$51,000,000 from Prudential Insurance;

• 2. Shell receives NZ$33,660,000 from Barclays;

• 3. Shell receives NZ$68,340,000 from Amsterdam-Rotterdam;

• 4. Shell receives US$102,014,438 from Sumitomo;

• 5. Shell pays NZ$151,875,000 to Sumitomo;

• 6. Shell pays NZ$1,125,000 to Goldman, Sachs & Co.;

• 7. Goldman, Sachs & Co. pays NZ$1,125,000 to Sumitomo;

• 8. Sumitomo pays US$755,662 to Goldman, Sachs & Co.;

• 9. Prudential pays US$34,256,700 to Sumitomo;

• 10. Prudential receives NZ$51,000,000 from Sumitomo;

• 11. Barclays pays US$22,609,422 to Sumitomo;

• 12. Barclays receives NZ$33,600,000 from Sumitomo;

• 13. Amsterdam pays US$45,903,978 to Sumitomo;

• 14. Amsterdam receives NZ$68,340,000 from Sumitomo.

8 The foregoing is graphically illustrated in this way:

[graphic not reproduced].

9 The interest at 15.40% per annum on NZ$150,000,000 is NZ$23,100,000 or NZ$11,550,000 semi-annually which amount appears in the Summary of Forward Transactions (supra). This is the amount to be received by Shell from Sumitomo on the due dates regarding interest. It is also the amount payable semi-annually to the debenture holders, namely Amsterdam $5,159,000; Prudential $3,850,000; Barclays $2,541,000 for a total of $11,550,000.

10 On May 9, 1988 Mr. Gary Stewart of Shell calculated a gain arising out of the debentures and the hedging transactions of US$21,165,000 to be realized by Shell on May 10, 1993. This was not a speculative figure, but was a certainty for these reasons. On May 10, 1988 the principal amount of the NZ$ debt was $150,000,000 in respect of which Shell received from Sumitomo US$100,755,000.[FN3: <p><p><table><thead><tr><th>May 10, 1988</th></tr></thead><tbody><tr><td></td><td></td><td>NZ$</td><td>Exchange Rate</td><td>US$</td></tr><tr><td>Issuance:</td></tr><tr><td></td><td>Principal</td><td>$150,000,000</td><td>.6717</td><td>$100,755,000</td></tr><tr><td></td><td>Premium</td><td>3,000,000</td><td>.6717</td><td>2,015,100</td></tr><tr><td></td><td>Commission</td><td>(1,125,000)</td><td>.6717</td><td>(755,662)</td></tr><tr><td></td><td>Net Proceeds</td><td>$151,875,000</td><td>.6717</td><td>$102,014,438</td></tr></tbody></table></p></p>] On May 10, 1988 the forward conversion rate agreed upon in respect of the hedging transactions for May 10, 1993 was by necessary inference from the Summary of Forward Transactions .5306. On May 10, 1993 the NZ$150,000,000 was repaid and this required US$79,590,000 based on the .5306 rate. Hence the known gain on May 9, 1988 was US$100,755,000 - US$79,590,000 = US$21,165,000.

11 In its returns of income for 1992 and 1993 Shell deducted the semi-annual interest payments in respect of 1992 and 1993. These deductions, however, were not the CDN$ equivalent of the NZ$ required to make the semi-annual payments under the debenture agreements, but rather the CDN$ equivalent of the amount that it was required to pay in US$ under the hedging transactions to obtain the NZ$.

12 Turning now to the gain on the retirement of the loans, in its return of income for 1993 Shell reported a capital gain of $26,191,686 (taxable gain 75% = $19,643,765). Shell said that this represented the Canadian equivalent of US$21,165,000.

13 At trial Shell submitted that the US$21,165,000 consisted of two gains: one, in relation to the loan repayment amount and the other, the gain on the hedging transactions. Shell said that its gain on the debentures was US$19,185,000 and the second gain arising out of the hedging transactions was US$1,980,000. Shell arrived at this breakdown by calculating the loan repayment amount using the NZ$/US$ spot rate on May 10, 1993 which was .5438. The gain on the hedging transactions then was simply the difference between the amount in US$ required to retire the NZ$150,000,000 on May 10, 1993, i.e. US$79,590,000 and the value in US$ of the NZ$150,000,000 using the spot rate of .5438, namely, US$81,570,000 (US$81,570,000 - US$79,590,000 = US$1,980,000).

14 The Minister disallowed a portion of the semi-annual payments. Essentially he disallowed the difference between the New Zealand rate, 15.40%, and the market rate for US$ for a five-year loan to Shell on May 10, 1988. The basis for the reassessment was that relative to the US$ proceeds of the borrowing (US$100,755,000 without the premium), the amounts claimed by Shell as interest expense represented an interest rate in US$ of approximately 14.7% at the beginning of the five-year loan, declining to about 12.4% at the end of the period. Specifically, the Minister allowed an interest rate of about 8.7%. The Minister's calculation had as its starting point, 9.1%, the market rate of interest on a US$ borrowing for five years.[FN4: <p>It was established in the course of cross-examination by counsel for the respondent and noted in argument on behalf of the respondent that for financial statement purposes Shell adopted 9.1% per annum as the rate of interest payable over the five-year term pertaining to the NZ$. What is said in such statements by a taxpayer may in some circumstances be relevant, e.g. regarding an issue of credibility. But they are in no way binding on this Court. Nor do they preclude a taxpayer from taking a different position in challenging reassessments of liability to tax.</p>] The 2% premium, payable under the debenture agreements (NZ$3,000,000 = US$2,015,100), which was received by Shell on May 10, 1988 but not included in its 1988 income, was factored in to arrive at 8.7%.

15 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.

16 Regarding sham, reference is made to what Robertson J.A. said speaking for a majority of the Federal Court of Appeal in Paxton v. R. (1996), 97 D.T.C. 5012 (Fed. C.A.), at 501:

“The classic definition of sham is found in Lord Diplock's reasons in Snook v. London& West Riding Investments Ltd., [1967] 1 All E.R. 518 at 528:

I apprehend that, if it has any meaning in law, it means acts done or documents executed by the parties to the “sham” which are intended by them to give to third parties or to the court the appearance of creating between the parties legal rights and obligations different from the actual legal rights and obligations (if any) which the parties intend to create. One thing I think, however, is clear in legal principle, morality and the authorities ..., that for acts or documents to be a “sham”, with whatever legal consequences follow from this, all the parties thereto must have a common intention that the acts or documents are not to create the legal rights and obligations which they give the appearance of creating. No unexpressed intentions of a “shammer” affect the rights of a party whom he deceived.

That definition was adopted by the Supreme Court of Canada in Minister of National Revenue v. Cameron, [1974] S.C.R. 1062 at 1068per Martland J. It was reaffirmed by that Court in Stubart Investments Limited v. R., [1984] 1 S.C.R. 536 at 545-56. As Professor Krishna has written, the definition of sham implies that the parties to a transaction have deliberately set out to misrepresent the actual state of affairs. In other words, deceit is the cornerstone of the sham doctrine: see V. Krishna, The Fundamentals of Canadian Income Tax, 5th ed. (Scarborough: Carswell, 1995) at 1371-72.

17 Further, the fact that what was done was premised on Shell's anticipation that it would secure the tax benefits previously described is not to be construed as operating to its detriment in this litigation. In Stubart Investments Ltd. v. R. (1984), 84 D.T.C. 6305 (S.C.C.)Mr. Justice Estey said at pages 6311-12:

What then is the law in Canada as regards the right of a taxpayer to order his affairs so as to reduce his tax liability without breaching any express term in the statute? Historically, the judicial response is found in Bradford Corporation v. Pickles, [1895] A.C. 587where it was stated:

If it was a lawful act, however ill the motive might be, he had a right to do it. If it was an unlawful act, however good his motive might be, he would have no right to do it. (per Lord Halsbury L.C. at p. 594)

No use of property, which would be legal if due to a proper motive, can become illegal because it is prompted by a motive which is improper or even malicious. (per Lord Watson at p. 598)

In the field of taxation itself the traditional position was re-echoed in I.R.C. v. Duke of Westminster, [1936] A.C. 1at p. 19 where it was stated:

Every man is entitled if he can to order his affairs so as that the tax attaching under the appropriate Acts is less than it otherwise would be. If he succeeds in ordering them so as to secure this result, then, however unappreciative the Commissioners of Inland Revenue or his fellow taxpayers may be of his ingenuity, he cannot be compelled to pay an increased tax.[FN5: <p>This statement of the law was reaffirmed by the Federal Court of Appeal in<em>R. v. Irving Oil Limited</em>, 91 D.T.C. 5106 at 5114and<em>Moloney v. R.</em>, 92 D.T.C. 6570.</p>]

18 In Tennant v. R. (1996), 96 D.T.C. 6121 (S.C.C.)Mr. Justice Iacobucci said at page 6127:

Further, the approach taken by the courts below in the instant appeal fails to reflect the economic reality of the situation. The appellant in this case has reinvested all the proceeds of disposition of the Realwest shares into the purchase of the TWL shares, and both these transactions are directly traceable to the original loan. As Dickson, C.J. stated in Bronfman Trust, ([1987] 1 S.C.R. 32) at p. 52-53, courts should strive to focus on the economic realities of a transaction, rather than juristic classifications:

I acknowledge, however, that just as there has been a recent trend away from strict construction of taxation statutes (see Stubart Investments Ltd. v. R.[84 D.T.C. 6305],[1984] 1 S.C.R. 536, at pp. 573-79, and R. v. Golden[86 D.T.C. 6138],[1986] 1 S.C.R. 209, at pp. 214-15), so too has the recent trend in tax cases been towards attempting to ascertain the true commercial and practical nature of the taxpayer's transactions.

This is, I believe, a laudable trend provided it is consistent with the text and purposes of the taxation statute. Assessment of taxpayers' transactions with an eye to commercial and economic realities, rather than 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.

19 Mara Properties Ltd. v. R. (1996), 96 D.T.C. 6309 (S.C.C.)was decided three months after Tennant. I will deal later with reference to the second issue in that case, namely, the undue or artificial reduction of income under subsection 245(1) of the Income Tax Act (“the Act”). In the meantime it is noted that when it was before this Court, counsel for Mara said that he made “no bones about the fact that this was an entirely tax-motivated transaction”. On the first issue whether certain land formed part of Mara's inventory Kempo, T.C.J. found in favour of the taxpayer. This was reversed by a majority of the Federal Court of Appeal, McDonald J.A. dissenting. The subsection 245(1) issue was not taken to the Supreme Court and in brief oral reasons Mr. Justice La Forest said that he and his colleagues agreed with the conclusion reached by Judge Kempo and Mr. Justice McDonald. Nothing was said by Mr. Justice La Forest about the commercial and economic realities of the transactions that gave rise to the appeals.

20 The foundation stone of the respondent's case regarding the deductibility of interest is this statement by Crown counsel in paragraph 17 of Repondent's Outline of Argument that was filed with the Court:

The effect of the contractual arrangements entered into by Shell was a merger of the two contracts into one, to create a borrowing of US dollars and future obligations to pay US$ pursuant to a legal obligation to pay interest.[FN6: <p>In the course of oral argument counsel said:<blockquote><p>The effect of the contractual arrangements entered into by Shell was a merger of the two contracts into one, and what I mean by that is in effect you have to take the two contracts together because that is how they were entered into to create a borrowing of US dollars and future obligations to pay US dollars pursuant to a legal obligation to pay interest.</p></blockquote></p>]

21 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. Obligations created by taxpayers entering into contracts establish jural relationships that are not to be recharacterized without clear statutory or judicial authority to do so. By way of example, reference is made to current subsection 245(2) and paragraph 245(5)(c) of the Act.[FN7: <p><blockquote><p>245(2) Where a transaction is an avoidance transaction, the tax consequences to a person shall be determined as is reasonable in the circumstances in order to deny a tax benefit that, but for this section, would result, directly or indirectly, from that transaction or from a series of transactions that includes that transaction.</p><ul>245(5) Without restricting the generality of subsection (2),<li><p>(c) the nature of any payment or other amount may be recharacterized,</p></li>in determining the tax consequences to a person as is reasonable in the circumstances in order to deny a tax benefit that would, but for this section, result, directly or indirectly, from an avoidance transaction.</ul></blockquote></p>]

22 In deducting the interest at issue in computing its income Shell relied on paragraph 20(1)(c) of the Act. It reads:

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.

23 I regard it as significant that the paragraph itself stipulates that the amount that can be deducted by way of interest must be “a reasonable amount”. To my mind this connotes that apart entirely from other provisions of the Act I must, in determining these appeals, be satisfied that what is allowed to be deducted as interest is reasonable. I have already indicated that I regard the 15.40% per annum provided for under the debentures to reflect a relevant market established rate. I think it follows that this rate is acceptable as reasonable in relation to the borrowing of NZ$ at the relevant time and it does not mutate into an unreasonable rate, as suggested on behalf of the respondent, because of the US$21,165,000 gain realized on May 10, 1993.

24 It is contended on behalf of the respondent that the NZ$ obtained by Shell from the lenders were never “used for the purpose of earning income from” its business. There is no doubt that the NZ$ were “borrowed money” which were immediately exchanged for US$ and the latter were used for Shell's general corporate purposes. I do not think that subparagraph 20(1)(c)(i) can properly be construed to hold that if a taxpayer borrows money for business purposes and immediately converts it into another currency that is used to earn income, the taxpayer is excluded from the benefit of deductibility conferred under that subparagraph in respect of the borrowed money. In the absence of some special circumstance, an example of which does not occur to me at the moment, the act of converting the borrowed money into another currency and employing the latter to earn income cannot of itself deprive what is borrowed of the character of being “borrowed money used for the purpose of earning income from a business” within the meaning of the subparagraph.

25 The respondent relies on section 67 and former subsection 245(1) of the Act. Section 67 reads:

67. In computing income, no deduction shall be made in respect of an outlay or expense in respect of which any amount is otherwise deductible under this Act, except to the extent that the outlay or expense was reasonable in the circumstances.

26 Subsection 245(1) reads:

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.[FN8: <p>This is the wording of the subsection prior to the enactment of S.C. 1988, c. 55, s. 185. The latter is applicable to transactions entered into on or after September 13, 1988.</p>]

27 Let us assume, however, that subsection 245(1) might be capable of application despite the test of reasonableness in paragraph 20(1)(c) having regard to what was said by Chief Justice Jackett in R. v. Alberta & Southern Gas Co. (1977), 77 D.T.C. 5244 (Fed. C.A.), at 524:

I cannot agree that the rule of interpretation [i.e., where there is a special section and a general section in the statute a case falling within the special section must be governed thereby and not by the general section] referred to by the learned Trial Judge excludes the application of section 245(1) to an amount that would otherwise be deductible under section 66. If it does, it is difficult to think of any case where section 245(1) would apply inasmuch as, in relation to any provision providing for a deduction in computing income, section 245(1) is always by its nature, a general provision. Parliament must have intended the provision to have some effect and a non-statutory rule of interpretation is merely a crystallization of the judicial reasoning in ascertaining Parliament's intention in enacting a particular provision.[FN9: <p>At issue in this case was paragraph 66(1)(<em>a</em>) which provided for the deduction of Canadian exploration and development expenses. It did not include within it a requirement of reasonableness.</p>]

28 The latest consideration of subsection 245(1) of the Act by the Federal Court of Appeal is Fording Coal Ltd. v. R. (1995), 95 D.T.C. 5672 (Fed. C.A.).[FN10: <p>Leave to appeal was refused (September 19, 1996), Doc. 25057 (S.C.C.).</p>] The years under appeal were 1985 to 1990. At issue was the deductibility of certain amounts under subsections 66.1(4) and 66.2(3) of the Act.[FN11: <p>What is said in footnote 7 about reasonableness also applies to subsections 66.1(4) and 66.2(3).</p>] They relate to a successor corporation's Canadian exploration expenses and a successor corporation's Canadian development expenses, respectively.

29 Strayer J.A. speaking for the majority (McDonald J.A. dissented) made a number of observations pertaining to subsection 245(1). He noted that if a deduction is contrary to the object and spirit of subsections 66.1(4) and 66.2(3) “it may be relevant to the application of subsection 245(1)”. (p. 5673) “The central issue is the undue or artificial nature of the reduction of income, not the artificiality of the transaction in question.” (p. 5675) He went on to say:

It has been held that one indicator that a deduction artificially reduces income is that it is based on a transaction or arrangement which is not in accordance with normal business practice. In the present case the deduction claim arises out of the seeding transaction which in my view was not in accordance with normal business practice. It should first be noted that the respondent admits that there was no bona fide business purpose for this transaction unrelated to tax avoidance. That of itself is not determinative of the artificiality of the deduction, but is certainly relevant. In Stubart Estey, J. specifically stated in obiter that, where a transaction has no bona fide business purpose, then subsection 245(1) ‘may be found to be applicable depending upon all the circumstances of the case’. (Subsection 245(1) had no application in that case because the Crown had not invoked it).

30 His Lordship went on to describe the nature of the seeding transaction on the same page:

The circumstances here underline the abnormality of the seeding transaction. It consisted of the respondent selling a minute interest (.001%) in the Fording Mine to Elco for $10,000, with an irrevocable option to repurchase. It is clear from the circumstances that both parties intended this interest to be repurchased very soon, as it was within 28 days. The only advantage to Elco in the seeding transaction was that it received a royalty of $116.49 in respect of minerals produced from the Fording mine during that period. It is difficult to see in this an arrangement in accordance with normal business practice. What is apparent is that by the temporary sale of this minute interest the respondent sought to deduct, from its income from the Fording River Coal Mine, over $13,000,000 of expenses incurred by Elco on Elco lands prior to their acquisition by the respondent.

In the Alberta and Southern Gas Co. case Jackett, C.J. looked to the object and spirit of the section permitting the deduction as a test of whether the deduction claimed would unduly or artificially reduce income. In that case he found the deduction to be within that object and spirit and therefore not to reduce income artificially. But I find that the deductions in the circumstances of the present case were contrary to the object and spirit of the Act. I do not understand the respondent to argue otherwise. The respondent simply relies on the literal interpretation of the Act as supporting its deductions. No one has suggested a rational legislative purpose which would be served by permitting the deductions in this case. I believe that the appellant has correctly described that intention as being to allow the purchaser of mining property to acquire along with that property (if the vendor so agrees) the benefit of unused tax pool deductions including CCEE and CCDE, available for use against income derived in the future from that property. There is eminent sense in encouraging: firstly, the initial investment through making expenses potentially deductible, with added value to the property by making those expense pools transferable to a purchaser; and secondly, the further development and putting into production of that same mining property by one who takes it over. But I can imagine no public purpose, nor has any been suggested, which would be served by allowing the deduction in the present case so as to allow the respondent to deduct, from future income from properties it previously owned, the expenses incurred in the past exploration and development of other newly acquired property which has produced nothing since its acquisition. In my view, these deductions being contrary to the object and spirit of the sections which nevertheless permit them, they may be seen as artificially reducing income.

31 In my opinion, there is nothing before me from which I can properly conclude that the interest deductions sought by Shell are not in accordance with normal business practice. The fact that business transactions may be regarded as convoluted does not, of course, mean that they are abnormal. Further, I do not regard the debenture agreements and the hedging transactions to be contrary to the object and spirit of paragraph 20(1)(c). Bronfman Trust v. R. (1987), 87 D.T.C. 5059 (S.C.C.)and subsequent decisions provide the necessary guidance to the meaning and application of that paragraph. Those agreements and transactions in no way resemble the “abnormality” of the seeding transaction in Fording Coal.

32 While I am unable to reconcile the various pronouncements made and conclusions arrived at regarding judicial or statutory tax avoidance by the two courts to which the Tax Court is bound by the doctrine of stare decisis, I think this is manifest: taxpayers can successfully engage in transactions designed for their monetary benefit that are premised on anticipated favourable tax treatment. But the dividing line between what is permissible tax planning and prohibited tax avoidance is not easily discernible.

33 In Mara which is discussed earlier the appellant reported a loss in 1992 on the disposition of land it had acquired from a subsidiary on the latter being wound up. The land had been the subsidiary's only inventory asset at the time of the winding up. The sole purpose of a series of transactions relating to the foregoing had been the utilization by the appellant of rollover provisions in subsection 88(1) of the Act to acquire for itself unused capital losses of the subsidiary. In reassessing the Minister disallowed the 1992 loss and losses carried forward in subsequent years. The appeals to this Court were heard by Kempo, T.C.J.((1993), 93 D.T.C. 1449 (T.C.C.)) who allowed them. It was held that subsection 245(1) of the Act had no application. Further, it was determined that the land became part of the appellant's inventory and the loss incurred on its disposition was deductible as a business loss. She said at page 1451:

These series of transactions were motivated solely for the purpose of reducing tax. Appellant's counsel's words cut to the core:

Now let's be clear, Your Honour. We make no bones about the fact that this was an entirely tax-motivated transaction. We make no bones about the fact that there was no reasonable expectation of profit in property where we acquired it at noon and sold it by dusk for a loss of four and a half million dollars.

That this was factually correct was elicited from Mr. Ralph Schmidtke, an officer of the Appellant.

34 An appeal to the Federal Court of Appeal was allowed (95 D.T.C. 5169) because a majority of that Court interpreted relevant provisions in subsection 88(1) of the Act differently than the view taken by Judge Kempo. But the Court of Appeal did not rely on undue or artificial reduction of income. Marceau J.A. said at 5169: “I also accept that subsection 245(1) of the Act, concerning artificial transactions, has no role to play in the factual context of this case.” The appeal to the Supreme Court of Canada was allowed from the Bench:(1996), 96 D.T.C. 6309 (S.C.C.). Mr. Justice La Forest, speaking for the Court, said at page 6310:

We agree with the conclusion reached by the Tax Court and Mr. Justice MacDonald, (sic) the dissenting judge in the Court of Appeal. In our view, in the circumstances of this case, the property retained its character as inventory in the hands of the appellant.

Accordingly, the appeal is allowed with costs throughout, the judgment of the Court of Appeal is set aside, and the judgment of the Tax Court is restored.

35 Shell is entitled to succeed on the issues about the deductibility of interest on this basis: I regard interest in a reasonable amount under paragraph 20(1)(c) to be the amount payable in respect of 1992 and 1993 under the debentures, as interest in NZ$ converted to CDN$ at the generally accepted rate of exchange applicable in the market on the days those amounts became payable. As previously indicated in its returns of income Shell deducted in respect of the semi-annual interest payments the CDN$ equivalent of the US$ amounts that it was required to pay under the applicable hedging transactions in order to obtain the NZ$. I disagree with this approach. As previously stated there was no existing legal obligation between Shell and Sumitomo regarding the payment of interest. The presence of a legal obligation to pay interest is mandatory to deductibility under paragraph 20(1)(c) of the Act.

36 With reference to the issue whether the US$21,165,000 gain was on capital account or was business income: I think that unless there is some particular feature signifying the contrary, if a taxpayer enters into an agreement to borrow a specified amount for a fixed period of five years for the purpose described in subparagraph 20(1)(c)(i) that is to be regarded as a capital transaction. The existence of gains or losses arising out of related foreign exchange transactions does not alter this. There being no particular feature in the case at hand the gain is capital in nature. In Beauchamp (Inspector of Taxes) v. F.W. Woolworth plc (1989), [1990] 1 A.C. 478 (Eng. H.L.)Lord Templeman, with whom the other four Law Lords who heard the appeal concurred, said at page 493:

The authorities do not support the proposition that a borrowing of a definite sum for a fixed term of five years can be an income transaction.[FN12: <p>In the 1992 supplement to<em>Whiteman on Income Tax</em>the author said at page 44:<blockquote><p>While it may very well be the case that a five-year facility will be revenue in nature only in the rarest of circumstances and that the loans under consideration could not be so described by any reasonable body of Commissioners, it is submitted that [this] last dicta [goes] too far. Surely the question of whether or not a transaction is on income or capital account depends upon its circumstances and it must be possible that in the myriad of complex transactions that take place in the commercial world one will arise where as a matter of commercial reality a five-year term loan is on revenue account. To hold, as Lord Templeman has effectively done, that as a matter of law, such a loan is always on capital account is, it is submitted, to burden our jurisprudence with an unnecessary rule.</p></blockquote></p>]

37 In Beauchamp the taxpayer, a large scale retailer of a wide range of articles, sustained losses in converting borrowed Swiss francs into sterling. The transactions related to the losses are described at page 490 of the report:

In 1971 the taxpayer borrowed 50 million Swiss francs repayable in five years' time or earlier at the option of the taxpayer, subject to a premium for early repayment. The taxpayer converted the Swiss francs into sterling. In 1976 the taxpayer purchased 50 million Swiss francs and repaid the loan to the lender, a Swiss bank. In 1972 the taxpayer borrowed a further 50 million Swiss francs and converted them into sterling. In 1977 the taxpayer purchased and repaid 50 million Swiss francs. As a result of a fall in the value of sterling in relation to Swiss currency, the proceeds of converting 100 million Swiss francs into sterling in 1971 and 1972 were £11.4m. less than the cost to the taxpayer of purchasing and repaying 100 million Swiss francs in 1976 and 1977. The taxpayer undoubtedly incurred a currency exchange loss of £11.4m.

38 Lord Templeman said at page 491:

My Lords, the weight of authority supports the view that the question whether the transactions in the present case were of a revenue or capital nature is a question of law to be determined in the light of the facts found by the commissioners, and that a trader who borrows 100 million Swiss francs for a fixed period of five years thereby enlarges the capital employed in the trade.

A trading company which borrows unconditionally a fixed amount for a definite period may use the money generally for the purposes of its business or for any other purpose authorised by its constitution, and even when the money is employed in the business, the money may be laid out on income expenditure or capital expenditure. The taxpayer could do as it pleased with 100 million borrowed Swiss francs, provided that the application of the money was intra vires the objects of the taxpayer company. The commissioners found as a fact that the taxpayer intended to use the 100 million Swiss francs to overcome a difficulty which was hoped to be of short duration and which was caused by the fact that stocks were high and trade depressed. But there was nothing to stop the taxpayer spending the whole or part of the money on capital items, and indeed part was spent on capital items. For my part, I do not attach any importance in the present circumstances to the intentions of the taxpayer or to the actual use made of the money in the present circumstances. The 100 million Swiss francs, worth some £10m., were available to the taxpayer as additional capital.

Mr. Park submitted that an asset or advantage which only endured for five years was not enduring, although a loan which endured for 10 years would be sufficiently enduring. But when a taxpayer borrows money for five years, he obtains an asset or an advantage which endures for five years and the authorities show that such a loan increases the capital of the taxpayer for that period. A loan is only a revenue transaction if it is part of the ordinary day to day incidence of carrying on the business. ...A loan is not an ‘ordinary incident of marketing’ unless, as the authorities show, the loan is temporary and fluctuating and is incurred in meeting the ordinary running expenses of the business.

In their stated case the special commissioners [1987] S.T.C. 279, 289-290, said:

the issue we have to decide is whether the borrowing took place in such circumstances that the borrowed moneys are to be regarded as an addition to the taxpayer company's capital resources or whether the borrowing formed part of the day to day activities in the earning of profits in the business.

In my opinion, that question only permitted one answer: the borrowing itself did not form part of the day to day activities of the taxpayer in earning profits.

39 Assuming that there were two gains as alleged by the appellant I see no reason why the gain in respect of the hedging transactions should be regarded as being different in character from the gain on the debentures. I think that it can be taken from Dominion Steel & Coal Corp. v. Minister of National Revenue (1957), 57 D.T.C. 147 (Can. Tax App. Bd.), at 15; Alberta Gas Trunk Line Co. v. Minister of National Revenue (1971), 71 D.T.C. 5403 at 5406 (S.C.C.); Neonex International Ltd. v. R. (1978), 78 D.T.C. 6339 (Fed. C.A.), at 634; Beauchamp (supra) at 490 that as a general rule if a taxpayer hedges its liability under a contract the hedging transaction assumes the same attribute regarding capital or income as the contract being hedged.

40 The appellant is entitled to party and party costs subject to the order I made in this regard on January 8, 1997 in respect of an interlocutory motion.