Macmillan Bloedel Ltd. v. The Queen, 90 DTC 6219, [1990] 1 CTC 468 (FCTD)

Collier, J.:—This is an appeal by the plaintiff from assessments and reassessments, by the Minister of National Revenue, in respect of the plaintiff's 1974 taxation year. Two other appeals by the plaintiff were heard at the same time: T-4526-82 and T-4020-82. The first is in respect of the 1975 taxation year; the second, in respect of the 1976 taxation year.

Initially, there were a large number of issues and differences between the parties. Fortunately, and laudably, by the time these appeals reached trial, the parties had come to agreement on a large number of matters. Consent judgments, covering the agreements reached, were filed on April 3, 1986. Further consent judgments were filed at this hearing.

Two issues remain for decision.

One is what was described as the foreign exchange loss issue. It is relevant only to the 1974 taxation year. The second is the logging tax issue. It is relevant in each of the three years.

The reasons for judgment in this appeal (action) will apply, where relevant, in the other two.

An agreed statement of facts was filed (Exhibit 7). The plaintiff called one witness of fact: J.C. Finkbeiner, the plaintiff's Vice-President of Tax, Property and Risk Management. He spoke to the two outstanding issues previously referred to. Each party called an expert witness (both chartered accountants) in respect of the foreign exchange loss.

Background:

The plaintiff is a large corporation with its head office in Vancouver, British Columbia. In the material years, it carried on an integrated forest products business in British Columbia. Its business involves all aspects of the industry, including forest management, harvesting timber, manufacturing lumber, pulp paper and other related products, as well as the sale of those products. The plaintiff has approximately 130 subsidiaries, in Canada and in other countries, mostly wholly owned by it (see exhibit 8). Most of the subsidiaries are in the business of manufacturing or selling forest products. In respect of the harvesting of timber, approximately 75 per cent is carried on in British Columbia.

The Logging Tax Issue:

In filing its returns for the three taxation years, the plaintiff reported all of its income was earned in British Columbia. The majority of that income came from its logging, manufacturing and sale operations in that province. Under the applicable legislation there, the plaintiff became liable to pay logging taxes to the province. To arrive at the taxes, the province assessed the plaintiff's taxable income under the provincial legislation, then levied a 15 per cent tax.

The plaintiff, then, in its returns filed under the Income Tax Act, claimed a logging tax deduction, as permitted by subsection 127(1) of that statute:

127. (1) There may be deducted from the tax otherwise payable by a taxpayer under this Part from a taxation year an amount equal to the lesser of

(a) 2/3 of any logging tax paid by the taxpayer to the government of a province in respect of income for the year from logging operations in the province, and

(b) 6 2/3% of the taxpayer's income for the year from logging operations in the province referred to in paragraph (a),

except that in no case shall the aggregate of amounts in respect of all provinces that would otherwise be deductible under this section from the tax otherwise payable by the taxpayer under this Part for the year exceed 6 2/3% of the amount, if any, by which the taxpayer's taxable income for the year or taxable income earned in Canada for the year, as the case may be, exceeds, where the taxation year ends after 1976, the lesser of

(c) the amount, if any, in respect of the taxpayer determined under paragraph 124(2)(a) for the year, and

(d) the amount, if any, in respect of the taxpayer determined under paragraph 124(2)(b) for the year.

(2) In subsection (1),

(a) “income for the year from logging operations in the province" has the meaning assigned by regulation; and

(b) "logging tax" means a tax imposed by the legislature of a province that is declared by regulation to be a tax of general application on income from logging operations.

The subsection was amended by S.C. 1974-75, c. 26, subsection 85(1). But the amendment was applicable only to 1977 and subsequent taxation years.

Section 700 of the Income Tax Regulations sets out the meaning of "income for the year from logging operations in the province”. I shall reproduce only those parts of the Regulation which counsel deemed applicable to this action:

700. (1) Except as provided in subsection (2), for the purpose of section 41 A[127] of the Act "income for the year from logging operations in the province” means the aggregate of

(a) where standing timber is cut in the province by the taxpayer or logs cut from standing timber in the province were acquired by the taxpayer, if the logs so obtained are sold by him in the province prior to or on delivery to a sawmill, pulp or paper plant or other place for processing logs, his net profit for the year from the sale of the logs;

(c) where standing timber is cut in the province by the taxpayer or logs cut from standing timber in the province are acquired by the taxpayer, if the logs thus obtained are

(i) exported from the province and are sold by him prior to or on delivery to

a sawmill, pulp or paper plant or other place for processing logs, or

(ii) exported from Canada,

the amount computed by deducting from the value, as determined by the province, of the logs so exported in the year the aggregate of the costs of acquiring, cutting, transporting and selling the logs; and

(d) where standing timber is cut in the province by the taxpayer or logs cut from standing timber in the province have been acquired by the taxpayer, if the taxpayer operates a sawmill, pulp or paper plant or other place for processing logs in Canada, the income of the taxpayer for the year from all sources minus the aggregate of

(i) his income from sources other than logging operations and other than the processing and sale by him of logs, timber and products produced therefrom,

(ii) any amount included in the aggregate determined under this subsection by virtue of paragraph (a), (b) or (c), and

(iii) an amount equal to 8% of the original cost to him of properties described in Schedule B to these Regulations used by him in the year in the processing of logs or products derived therefrom or, if the amount so determined is greater than 65% of the income remaining after making the deductions under subparagraphs (i) and (ii), 65% of the income so remaining or, if the amount so determined is less than 35% of the income so remaining, 35% of the income so remaining.

Paragraph 700(1)(d) is the provision which gives rise to most of the disputes between the parties.

The Minister of National Revenue, in his reassessments, excluded the following amounts which the plaintiff had included in its calculation of income for the year from its logging operations:

These excluded amounts were, for the most part, interest received from various sources, including substantial interest on overdue trade accounts receivable. The Minister's position was, and is, that the amounts were income from other than logging operations (see subparagraph 700(1 )(d)(i) of the Regulations). The above total sums were broken down into various categories, all set out in Schedule I to the agreed statement of facts. I attach a copy of Schedule I as an appendix to these reasons.

I shall deal with the various categories in the schedule, using the numbering system there set out.

Category 1(a)

The defendant agreed the first four items of bank interest should be included in the income calculation. To put it another way, the assessment should not exclude those items.

In respect of the remaining items in 1(a), there was no evidence given to me as to how, or why, these alleged interest amounts arose. It is not enough to say, as I see it, the plaintiff was carrying on an integrated forest products business, and these items must have arisen out of that business. There must be something, factually, more than that. Those items ought not to be included in the calculation of income, and were properly excluded by the Minister.

Category 1(b)

The items reading Russell & DuMoulin is interest from the trust account of a firm of solicitors who presumably acted for the plaintiff in some transaction or transactions. Once again, there was no evidence before me indicating these items of interest arose specifically out of logging operations.

It was conceded by the plaintiff that the interest, from Revenue Canada on income tax refunds, should not be included in the calculation of income. It was, therefore, properly excluded by the Minister.

Category 2

This category is described as rebates and recoveries. I have difficulty in comprehending how these amounts can be said to arise out of the plaintiff's income source of logging operations. There was no factual evidence explaining these items. The onus is on the plaintiff to show the Minister’s assessment is wrong. That onus has not been met in respect of this category.

Category 3

The plaintiff, by way of mortgages or advances, assisted employees who were required to move. Interest on those loans was paid to the plaintiff employer. I am satisfied this method of assisting employees was, from a practical and business point of view, part of the plaintiff's logging operations. The amounts for the two years in question ought to be included in income.

Category 4

These items were described as interest on temporary surplus cash. The amounts arose mainly from short term deposits. The funds, put on deposit, undoubtedly originated from profits, or income from logging operations. But, in my view, that is where, in the business and tax sense, the matter ended. The plaintiff chose to put the funds in interest bearing accounts. The resulting gain came, to my mind, from a new source and not from logging operations.

Category 5

The plaintiff charged its customers interest on overdue trade accounts. Additionally in this cateogory, there are three companies, all subsidiaries of the plaintiff. One operated in the United Kingdom, and two in the United States. These companies sold the plaintiff's products in those countries. They, like the non-related trade customers, were charged interest on their overdue accounts.

The defendant contended all these transactions were really interest bearing loans by the plaintiff. The source of this income, it was said, was that of a lender.

I do not accept that submission.

It seems to me a perfectly normal business transaction to charge interest on overdue accounts. The products, and their sale, all come from the plaintiff's logging operations. The price ultimately realized included the charge for delayed payment. From a business and the section 127 tax viewpoint, the plaintiff’s treatment of these amounts was correct. The Minister’s assessment will be varied to take these amounts into account.

Category 6

The plaintiff made loans or advances to certain non-subsidiary customers, and charged interest on them. Evergreen Press, for example, was a purchaser of paper products. Loggers and North Central Plywood were supply sources of certain materials. Counsel for the defendant put forward the same submissions as were made in respect of Category 5. For the same reasons, I concluded this was part and parcel of the plaintiff's logging operations, and not some separate source of business income. The assessment will be varied in respect of this category.

Category 7

The plaintiff conceded these amounts should not be included in the calculation of income from logging operations.

Category 8

The plaintiff loaned funds to certain subsidiaries to provide working capital. These subsidiaries were marketing the plaintiff’s products, one in the United Kingdom, and two in the United States. Interest was paid on those loans. (The plaintiff conceded the interest received from Celupal S.A. should not be included in the calculation of its logging operations’ source of income.)

Counsel for the Crown took the same position on this category as was done in respect of Categories 5 and 6. For the same reasons, I reject the contention. These loans were an integral part of the plaintiff's whole operation, done to facilitate the marketing of its products.

Category 9

The defendant conceded this amount should be included in the section 127 calculation.

Categories 10 and 11

The plaintiff conceded these amounts should be excluded from income from logging operations, for the purpose of the tax credit provisions.

Category 12

I was told this matter had been settled, and I need not deal with it.

Adjustments

This appears to have been expense amounts which were deducted twice in the calculation by the plaintiff. Accordingly, the income figure should be increased accordingly. I see no difficulty with that adjustment. That amount should be added into the calculation of income from logging operations.

That concludes the logging tax issue.

The Foreign Exchange Loss Issue:

In its 1974 taxation year, the plaintiff claimed a deduction of $680,800. It was asserted to be a foreign exchange loss in the course of borrowing money to gain or produce income. The Minister disagreed. He disallowed the deduction. The relevant portion of the Income Tax Act was subparagraph 20(1)(e)(ii):

20. (1) Notwithstanding paragraphs 18(1)(a), (b) and (h), in computing a taxpayer's income for a taxation year from 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:

(e) an expense incurred in the year,

(ii) in the course of borrowing money used by the taxpayer for the purpose of earning income from a business or property (other than money used by the taxpayer for the purpose of acquiring property the income from which would be exempt),

This is a somewhat complicated issue. Rather than attempt to summarize it, I shall set out the relevant portions of the agreed statement of facts:

(a) The long term financing requirements for 1974 were first formally considered at a meeting of the Board of Directors of the plaintiff on February 18, 1974. At that meeting the Board was advised that management planned to borrow U.S.$75,000,000 of which U.S.$35,000,000 would be borrowed immediately and U.S.$40,000,000 would be borrowed in May or June 1974.

(b) The Executive Committee of the Board of Directors met on March 1, 1974 and were informed that steps were being taken to issue U.S.$75,000,000 of debentures in a private placement bearing 8 3/4 per cent interest. The issue provided for a first drawing of U.S.$50,000,000 during the last half of April, 1974 with the balance available at June 30, 1974.

(c) The Executive Committee met again on April 5, 1974 and was told a U.S.$70,000,000 private placement was planned and that a meeting was scheduled with the lenders for April 10, 1974. The Executive Committee resolved to allow management to borrow up to U.S.$75,000,000 at a rate up to 9 per cent.

(d) Following the meeting with the lenders in April, 1974 the plaintiff arranged foreign exchange cover in respect of the proposed transaction. It did this by entering into foreign exchange or forward hedging contracts. The contracts entered into required the plaintiff to deliver U.S.$48,000,000 between May 1 to 31, 1974 and U.S.$22,000,000 between July 1 to 31, 1974 at specified conversion rates. Management expected that these contracts would coincide with the delivery dates of the borrowed funds. The contracts were as follows:

(a) Royal Bank of Canada (Royal Bank)
(b) Canadian Imperial Bank of Commerce (CIBC)
(c) State Street Bank and Trust Company (State Street)
Bank	Amount	Rate	Delivery Date
Royal Bank	U.S. $23,000,000	.9659	May 1 to 31/74
CIBC	U.S. 25,000,000	.9656	May 1 to 31/74
State Street	U.S. 22,000,000	.9664	July 1 to 31/74

(e) On May 7,1974 the Royal Bank and the CIBC foreign exchange contracts were both extended to be delivered between June 1 to 30, 1974. The rate of exchange on both contracts remained the same.

(f) On May 27, 1974 the Executive Committee was told that the financing, planned at 8 3/4 percent, would close on May 28,1974 but completion of the financing was then delayed due to the restrictions the lenders were seeking to impose.

(g) The transaction did not close on May 28, 1974 and the Board of Directors met June 4, 1974, considered the restrictions being imposed and authorized the Executive Committee to approve all terms and conditions of a borrowing not exceeding U.S.$75,000,000 at a rate not exceeding 8 3/4 per cent.

(h) On June 26, 1974, the CIBC foreign exchange contract was extended to July 15, 1974 with the principal amount being reduced and the rate of exchange being changed. At the same time the Royal Bank contract was changed to two contracts, one for U.S.$10,000,000 and one for U.S.$25,000,000. These changes in contracts increased the amounts to the full U.S.$75,000,000 being borrowed. A summary of the contracts is set out below:

Bank	Amount	Rate	Delivery Date
Royal Bank (i)	U.S. $10,000,000	.9694	After July 9/74
(ii)	U.S. $25,000,000	.9692	After July 9/74
CIBC	U.S. $18,000,000	.9648	July 15/74
State Street	U.S. $22,000,000	.9664	July 1 to 31/74

(i) Continuing negotiations relating to the terms of the plaintiff's trust indenture delayed the closing until July 9, 1974. The spot rate on that date was .9744.

(j) On June 29,1974 the Royal Bank charged the Plaintiff $152,000 for extending its contracts.

(k) The purpose of the borrowing was to finance general corporate needs. The term of financing was considered to be long term by the plaintiff and its auditors.

(l) The Plaintiff calculated the $680,800 expense as follows

Funds borrowed	U.S. $75,000,000
Equivalent Canadian dollars at spot rate of .9744
on July 9, 1974	$73,080,000

Funds actually received in Canadian dollars:

State Street Bank and Trust Company	$21,260,800
Canadian Imperial Bank of Commerce	17,366,400
Royal Bank of Canada (i)		9,694,000
(ii)	24,230,000
	$72,551,200
Less payment to Royal Bank of Canada to extend
contract	$	152,000
Amount of debt recorded in plaintiffs books	$72,399,200
Difference between debt recorded and spot rate
receipt	$	680,800

The transaction with the three banks was referred to as “acquiring forward cover", or "forward hedging contracts". I shall refer to what was done as "the hedging contracts".

A hedging contract, against fluctuations in foreign currency is a common business practice. The expert witness, on behalf of the plaintiff, described a hedging contract as follows:

A foreign exchange hedging transaction is one that assures the party entering into it that it will receive a fixed dollar amount in relation to his future receipt of a foreign currency. Foreign exchange contracts are commonly entered into by persons wishing to avoid the risk of a fluctuation of a foreign currency. For example, if a company knows that it will borrow a fixed amount of U.S. dollars in six months it can be assured that a fixed amount of Canadian dollars will be received at that time by entering into a forward exchange contract with its bank.

The purpose in this case was to try and ensure a certain amount of Canadian dollars at the closing date of the plaintiff's borrowing of $75 million U.S. That date was July 9,1974. The hedging contracts with the banks first commenced in April, 1974. The plaintiff, in effect, agreed to sell to the banks, on July 9, 1974, $50 million U.S. in exchange for Canadian dollars at the foreign exchange rate on that date. The hedging contracts, however, were based on the rates set out in those agreements. If the universe had unfolded perfectly, and the exchange rates had coincided, the plaintiff would have received the equivalent Canadian dollars originally contemplated.

The essence of the hedge, and what happened here, is found in paragraphs (h), (i) and (I) of the agreed statement of facts. The banks agreed to deliver Canadian funds for U.S. dollars at exchange rates of .9694, .9692, .9648, and .9664. The spot exchange rate on July 9, 1974, (the closing of the borrowing from the U.S. lenders) was, however, .9744. In the plaintiff companies' books and records, the loan was recorded, according to accepted accounting principles, in Canadian dollars as $73,680,000. But, in fact, because of the hedging contracts entered into, the plaintiff received only $72,399.20. The loss or difference is claimed as an expense of the borrowing.

The plaintiff, at first, viewed and treated the loss as on account of capital. Then, it felt it was really an expense, deductible under subparagraph 20(1)(e)(ii).

As I earlier noted, each party put forward an expert witness. For the plaintiff, Mr. Beverly Harrison, a senior partner in the accounting firm of Arthur Andersen & Co. For the defendant, Dennis F. Culver, the senior partner in Culver & Co., chartered accountants, Vancouver, B.C. Both these witnesses were well qualified and experienced. Both agreed that in 1974, in the accounting field, there was virtually no guidance to be found in the Canadian Institute of Chartered Accountants (CICA) Handbook, in respect of the dispute here. By 1983, some guiding principles had been formulated and set out in the Handbook.

Mr. Harrison's opinion was the foreign exchange loss should be treated as an expense deductible in the year the borrowing was completed. He felt there were two separate transactions here, but they were being accounted for as one event. The first, he said, was the recording of the obligation to repay the U.S. borrowings; as earlier noted, that amount is properly recorded in Canadian dollars; the second transaction is the recording of the hedging transactions related to the borrowing. He then went on to classify the loss as a deductible expense. I quote from his evidence in chief:

Since the forward contracts were intended to protect the company from foreign exchange rate fluctuations (management's intent), the loss of $680,800 on the hedging activities should be netted with the proceeds of the financing on the balance sheet to show the Canadian dollar liability as it would have been had the transaction been concluded on April 5, 1984. Since the purpose of the hedging was the preservation of the amount of the Canadian dollar proceeds of the financing, the $680,800 is a foreign exchange loss incurred by MacMillan Bloedel Limited in its 1974 fiscal period. The amount should be treated as an expense under generally accepted accounting principles and should be reflected in the income statement of the Company as the principal amount of the Series F debenture is repaid, whether the principal is repaid over time or at maturity.

Mr. Culver would not accept the view there were two separate transactions. He felt the $680,800 loss was “inextricably” related to the loan transaction, and should be recorded as part of the transaction. He therefore went on to conclude the total transaction as capital in nature, and the amortization as capital, as well.

Both experts had honestly held views. I prefer the evidence of Mr. Harrison that, when one carefully analyzes the situation, there are, from a business and accounting view, two transactions. There was a loan obtained by the plaintiff in the United States. When the funds became available, there was another transaction: the obtaining of Canadian funds. The loss on the second transaction was, in my view, an expense incurred in the course of borrowing the U.S. funds.

Mr. Culver, in his evidence in chief, described the foreign exchange loss as a "cost", but seemed unwilling to characterize that cost as an expense. I so characterize it; and deductible under the subparagraph of the statute. Quite apart from accounting techniques or principles, it seems to fall clearly within subparagraph 20(1)(e)(ii).

That part of the Minister's reassessment for 1974, is therefore, vacated or varied.

I direct counsel for the plaintiff to prepare draft formal judgments (pronouncements) to accord with these reasons. I suggest the formal judgments should provide the income tax reassessments be referred back to the Minister for further reassessment on the basis

(a) the deduction for the foreign loss be allowed;

(b) the amounts excluded from the calculation of income, in respect of the logging tax credit, that I have ruled incorrectly excluded, be included.

If counsel consider it desirable to include the consent judgments in the draft judgments, that will be satisfactory. But it should be clearly set out in the draft, in case there are appeals, what portions are by consent.

The plaintiff has had substantial success in these three appeals. In my view, an appropriate disposition as to costs would be: the plaintiff shall recover 85 per cent of its taxable costs in this action; it shall recover 100 per cent of reasonable fees paid to the expert witness Harrison. In the other two actions, the plaintiff shall recover its taxable costs, but not for preparation for trial, or counsel fees at trial.

The draft judgments should be presented to counsel for the defendant for approval. Failing agreement as to form and contents, I shall settle the final form.

Appeals allowed in part.