Coblentz v. The Queen, 96 DTC 6531, [1996] 3 CTC 295 (FCA.)

Robertson J.A.: — This is an appeal from a decision of the Tax Court of Canada. Succinctly stated, the issue to be decided is whether a lump sum payment received by the appellant taxpayer, an American citizen and resident of Canada, is exempt from taxation in Canada by reason of the Canada-United States Income Tax Convention (1980), as amended (the “Convention”). The learned Tax Court Judge answered that question in the negative. While I am in respectful agreement, my supporting reasons follow a distinctly different path.

1. Facts

The agreed statement of facts and law upon which the case was argued and decided is reproduced in the reasons of the Tax Court Judge. Since his decision is now reported, I need only restate the relevant facts in a summary fashion (see Coblentz v. R., [1994] 1 C.T.C. 2661, 94 D.T.C. 1364 (T.C.C.)).

Prior to December, 1988, the taxpayer, a United States citizen, had been employed for 15 years in that country. During 1989, and while a resident of Canada, the taxpayer received a lump sum payment of $90,395 (U.S.) on the winding up of a pension fund operated by his former U.S. employer. In filing his 1989 U.S. tax return, the taxpayer included in “gross income” the total amount of the payment as required under the Internal Revenue Code (the “Code”). The taxpayer, however, elected to treat the entire payment as a lump sum distribution under section 402 of the Code. The purpose of the election was to have that amount subject to taxation utilizing the ten-year averaging rules. Because of the election, the “total taxable amount” of the lump sum payment was allowed as an itemized deduction from the taxpayer’s gross income pursuant to paragraph 402(e)(3) of the Code. In the circumstances, the entire payment was excluded from the taxpayer’s taxable income (taxable income gross income - deductions). The election also held the effect of precluding the taxpayer from claiming the “standard deduction and the deduction for personal exemptions’ pursuant to subsection 63(b) of the Code. The amount of U.S. tax with respect to the lump sum payment, utilizing the ten-year averaging rules, was calculated at $12,770 (U.S.), and added to the taxpayer’s total U.S. income tax liability. [Presumably, those rules permit taxation of lump sum payments at a reduced rate and that is why the taxpayer made the election.]

In filing his 1989 Canadian tax return, the taxpayer included the lump sum payment in income as required by paragraph 56(1 )(a) of the Income Tax Act. On the basis of subparagraph 110(l)(f)(i) of the Act, he deducted from his Canadian taxable income the amount of the lump sum payment ($111,560.68 Cdn.) as an amount exempt from taxation in Canada under Paragraph 1 of Article XVIII of the Convention which, on interjecting geographical locations, reads as follows:

Pensions and annuities arising in the U.S. and paid to a resident of Canada may be taxed in Canada, but the amount of any such pension that would be excluded from taxable income in the U.S. if the recipient were a resident thereof shall be exempt from taxation in Canada.

By reassessment, the Minister of National Revenue (the “Minister”) disallowed the exemption, presumably on the ground that Paragraph 1 of Article XVIII is not applicable. However, pursuant to paragraph 126(7)(c) of the Act, the Minister did allow the taxpayer to reduce his Canadian tax liability by deducting the $12,770 (U.S.) paid to the American government. The taxpayer appealed on the ground that the entire pension payment is exempt from taxation in Canada.

2. Decision Below

Before the Tax Court it was agreed that the Technical Explanation accompanying Article XVIII could be used for purposes of interpretation. The portion relevant to Paragraph 1 of that article reads as follows:

Paragraph 1 provides that a resident of a Contracting State is taxable in that State with respect to pensions and annuities arising in the other Contracting State. However, the State of residence shall exempt from taxation the amount of any such pension that would be excluded from taxable income in the State of source if the recipient were a resident thereof. Thus, if a $10,000 pension payment arising in a Contracting State is paid to a resident of the other Contracting State and $5,000 of such payment would be excluded from taxable income as a return of capital in the first-mentioned State if the recipient were a resident of the first-mentioned State, the State of residence shall exempt from tax $5,000 of the payment. Only $5,000 would be so exempt even if the first-mentioned State would also grant a personal allowance as a deduction from gross income if the recipient were a resident thereof. Paragraph 1 imposes no such restriction with respect to the amount that may be taxed in the State of residence in the case of annuities.

The above explanation provides that Canada must exempt from taxation the amount of any pension that would have been excluded from taxable income in the United States had the recipient been a resident of that country during a particular taxation year. In the numerical example outlined it is suggested, however, that a “personal allowance” granted as a deduction from gross income in the U.S. falls outside the scope of the exemption for amounts to be excluded from taxable income. Counsel for the Minister argued that the taxpayer’s election “not to take standard deductions and to itemize his deductions was a personal deduction” (Reasons at 1367/2664). The Tax Court Judge concluded that the success of the taxpayer’s appeal hinges on whether itemized deductions, including the deduction for the lump sum payment, constitute personal allowances as contemplated by the Technical Explanation. On the basis that itemized deductions are not available to trusts or estates, the Tax Court Judge concluded that such deductions are personal allowances and, therefore, the payment in question is not exempt from taxation in Canada.

3. Issues

Three principal issues are raised on appeal. First, the taxpayer argues that the Minister’s position results in double taxation, contrary to the clear intent of the Convention. Second, he argues that the itemized sum deduction accorded the taxpayer under section 402 of the Code is not a personal allowance as contemplated by the numerical example outlined in the Technical Explanation. Third, the Minister argues, and apparently for the first time, that the benefit flowing from Paragraph 1 of Article XVIII of the Convention is available only where a taxpayer is entitled to the deduction as a matter of right and not when it is dependent on the making of an election as was required in this case.

The first argument can be disposed of handily. The second and third require further elaboration and consideration. There is, however, one remaining disagreement between the parties. It focuses on the weight to be given to the Technical Explanation. Although at the end of the day this issue is not determinative of the appeal, it provides a convenient opportunity to outline the interpretative rules relevant to this analysis.

4. Interpretative Rules

It would not be productive to review each of the existing analytical frameworks upon which the task of treaty interpretation may be undertaken. For present purposes it is sufficient to begin with the interpretative rules as mandated by Articles 31 and 32 of the Vienna Convention on the Law of Treaties, (Can. T.S. 1988 No. 37), (the “Vienna Convention”):

Article 31

1. A treaty shall be interpreted in good faith in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in the light of its object and purpose.

2. The context for the purpose of the interpretation of a treaty shall comprise, in addition to the text, including its preamble and annexes: (a) any agreement relating to the treaty which was made between all the parties in connexion with the conclusion of the treaty; (b) any instrument which was made by one or more parties in connexion with the conclusion of the treaty and accepted by the other parties as an instrument related to the treaty.

3. There shall be taken into account, together with the context: (a) any subsequent agreement between the parties regarding the interpretation of the treaty or the application of its provisions;...

Article 32

Recourse may be had to supplementary means of interpretation, including the preparatory work of the treaty and the circumstances of its conclusion, in order to confirm the meaning resulting from the application of Article 31, or to determine the meaning when the interpretation according to Article 31 :

(a) leaves the meaning ambiguous or obscure; or

(b) leads to a result which is manifestly absurd or unreasonable.

Article 31(1) of the Vienna Convention is instructive to the extent that it does not embrace the notion that words must be given their plain or ordinary meaning, that is to say their literal meaning. Rather, ordinary meaning is to be determined only after consideration is given to the terms of the treaty in their context and in light of its object and purpose. This reading of Article 31 is consistent with the position of the Supreme Court of Canada in Crown Forest Industries Ltd. v. R., [1995] 2 S.C.R. 802, (sub nom. Crown Forest Industries Ltd. v. Canada) [1995] 2 C.T.C. 64, (sub nom. R. v. Crown Forest Industries Ltd.) 95 D.T.C. 5839. Therein Iacobucci J., writing for a unanimous bench, held that the purpose of the Convention has significant relevance to how its provisions are to be interpreted. Moreover, it was held that “in ascertaining these goals and intentions, a court may refer to extrinsic materials which form part of the legal context...without the need first to find an ambiguity before turning to such materials” at page 822 (C.T.C. 77, D.T.C. 5396). Both the decision of the Supreme Court in Crown Forest and Article 31(1) of the Vienna Convention support the understanding that literalism has no role to play in the interpretation of treaties. Equally, it seems to me that this understanding and approach already informs the interpretation of domestic tax legislation: see Antosko v. Minister of National Revenue, (sub nom. Canada v. Antosko) [1994] 2 S.C.R. 312, [1994] 2 C.T.C. 25, (sub nom. Antosko v. R.) 94 D.T.C. 6314 at page 326 (C.T.C. 31, D.T.C. 6319) and; Stubart Investments Ltd. v. R., (sub nom. Stubart Investments Ltd. v. The Queen) [1984] 1 S.C.R. 536, [1984] C.T.C. 294, 84 D.T.C. 6305 at pages 578 (C.T.C. 316, D.T.C. 6323) and 580 (C.T.C. 317, D.T.C. 6324).

I turn now to the scope or meaning of the term “context”. Article 31(2) of the Vienna Convention goes on to provide that the context is to include the text, preamble, annexes and any agreements or instruments made “in connexion with the conclusion of the treaty”. By contrast, Article 31(3) states that subsequent agreements “shall be taken into account” together with the context. At this point it may be asked whether the Technical Explanation falls within Article 31(2) or 31(3) or, for that matter, Article 32 which refers to “supplementary means of interpretation”. Correlatively, it may be asked whether the words “shall be taken into account” found in Article 31(3) lessen the interpretative weight to be given to documents which fall within its boundaries, at least when compared to those documents that come within the ambit of Article 31(2).

To appreciate the significance of the first question it must be recognized that the Technical Explanation was prepared by the U.S. Treasury Department and released on 26 April 1984, four years after the Convention was signed. The Canadian Department of Finance endorsed the Explanation four months after it was released:

Canada agrees that the comprehensive Technical Explanation issued by the U.S. Treasury Department under date of April 26, 1984, which supercedes the one issued on January 19, 1981, accurately reflects understandings reached in the course of negotiations with respect to the interpretation and application of the various provisions in the 1980 Tax Convention as amended. (Release no. 84-128 Aug. 16/1984)

The view has been expressed elsewhere that as a result of the Department of Finance’s endorsement, the Technical Explanation constitutes either an agreement or instrument within Article 31(2)(a) or (b) of the Vienna Convention or a subsequent agreement within Article 31(3)(a), rather than a supplementary means of interpretation within Article 32 of the Vienna Convention: see The Partners of Davies, Ward & Beck and Brian J. Arnold, Ward's Tax Law and Planning, vol. 6 (Toronto: The Carswell Co. Ltd., 1983) at 21-46.

While I am certain that the Technical Explanation does not fall within Article 32 of the Vienna Convention, it is arguable whether it falls within Article 31(2), or 31(3). Parenthetically, I note that in Crown Forest lacobucci J. relied upon the Technical Explanation but did not state which subsection of the Vienna Convention provided him with the basis for doing so. As I understand the taxpayer’s argument here, the Technical Explanation falls within Article 31(3) and, therefore, the Explanation can- not be used to contradict the ordinary meaning of Article XVIII of the Convention. The argument, of course, is premised on the understanding that the Explanation is not a document made “in connexion with the conclusion of the treaty” as required under Article 31(2). It is also premised on the understanding that there is a substantive difference between Article 31(2) which speaks of the interpretative “context” and Article 31(3) which speaks in terms of taking into ““account”. In short, it is argued that a document which falls within the latter article must be given less weight than one which comes within the former. Above all, the taxpayer maintains that the Explanation cannot be used to contradict an article of the Convention. Counsel for the Minister sidesteps this line of attack by insisting that his argument rests on the ordinary meaning of the terms found within Paragraph 1 of Article XVIII.

In the reasons that follow it will become evident that I am of the view that the Technical Explanation facilitates our understanding of Paragraph 1 of Article XVIII and does not contradict it. In reaching this conclusion I am mindful of Iacobucci J.’s instruction to have regard to the Convention’s purposes when interpreting its provisions. In my view, those purposes are central in resolving the legal debate which has arisen in this case. This is an appropriate place to outline the Convention’s purposes and, in particular, those surrounding Article XVIII.

The preamble to the Convention states that it has a twofold purpose. First, it seeks to eliminate the phenomenon of double taxation. Second, it seeks the prevention of fiscal evasion of taxes on income and capital. However, the purposes of the Convention are not so limited, even though the preamble to the Convention goes no further. I hasten to add that I am not the first to recognize that the purposes underlying Canada’s tax treaties are not as limited as usually thought: see David A. Ward, “Canada’s Tax Treaties” (1995) 43 Cdn. Tax J. 1719 at 1728: (“It might be more accurate to say that the main or principal purpose of Canada’s tax treaties is to allocate and limit taxing powers of the two Contracting States”).

Turning to the other paragraphs of Article XVIII, three other purposes are readily identifiable. First, Article XVIII seeks to limit the amount of tax that may be charged in the Contracting State in which certain types of payments arise (see Paragraph 2(a)). Second, it seeks to ensure that certain payments are subject to taxation in only one of the Contracting States (see Paragraph 5(a)). Third, Article XVIII seeks to ensure that certain payments which are exempt from taxation in one Contracting State remain exempt in the other (see Paragraph 6(b)). In my view Paragraph 1 falls within this third category. This will be made apparent as I deal with the other legal issues outlined above.

5. Analysis

Simply stated, this is not a case in which the taxpayer can validly raise the spectre of double taxation. It cannot be doubted that the payment in question was taxed in the hands of the taxpayer on two different occasions by two different authorities. The reality, however, is that double taxation is avoided once a Contracting State provides a tax credit for taxes paid in the other. This is what happened in the instant case. The taxpayer’s Canadian tax liability with respect to the lump sum payment was reduced by the very amount paid to the American government. His real complaint lies in the fact that the $90,395 (U.S.) lump sum payment attracted a rate of tax in the U.S. approaching 15%, while in Canada the combined marginal rate has to be significantly more. I hasten to add that the monetary difference is a matter of tax policy, not treaty interpretation.

Turning to the second issue, I am of the view that the itemized deduction permitted under paragraph 402(c)(3) of the Code cannot be characterized as a personal allowance. This is a convenient place to reproduce the numerical example outlined in the Technical Explanation (with the appropriate geographical interjections):

Thus, if a $10,000 pension arising in the United States is paid to a resident of Canada and $5000 of such payment would be excluded from taxable income as a return of capital in the United States if the recipient were a resident of the United States, Canada shall exempt from tax $5,000 of the payment. Only $5,000 would be so exempt even if the United States would also grant a personal allowance as a deduction from gross income if the recipient were a resident thereof.

[Emphasis added.]

For the Tax Court Judge the defining criterion for determining whether a deduction qualifies as a personal allowance is its availability to persons and not entities such as trusts or estates. In my respectful opinion, this position is untenable for the reason that that criterion is unjustifiably broad.

I do not find it necessary to embark on a detailed analysis of the possible scope of the term “personal allowance”. Prima facie that term contemplates the type of personal deduction available in Canada prior to the introduction of tax credits and at the time the Convention was signed. For example, personal exemptions or deductions conditioned on marital status and the number of dependent children come easily to mind. Should this basic understanding be taken to include all deductions available to taxpayers who do not qualify as a trust or estate? The answer must be no. Were it otherwise the application of such criteria would defeat, in my opinion, the very purpose underlying Paragraph 1 of Article XVIII. Let me explain utilizing the numerical example outlined in the Technical Explanation.

The numerical example envisages the situation where a portion of a lump sum pension payment received by a taxpayer would be excluded from his or her taxable income because it represents a return of capital. For example, a portion of the lump sum payment may represent a return of an employee’s non-deductible contributions to a pension plan and, therefore, represent a return of his or her “investment in the contract” or “tax-paid capital”: see Swiderski T., “Some New Wrinkles on an Old Problem: U.S. Retirement Plans Held by Canadians” (1991) 39 Cdn. Tax J. 231 at 240.

From the foregoing it is evident that the purpose of excluding from taxable income any amount which represents a return of capital is to ensure that it is not taxed twice in the Contracting State in which the payment originates. In this case the Contracting State is the U.S. In short, an American taxpayer’s periodic contributions to a pension plan may well represent after-tax dollars and therefore the U.S. has determined, as a matter of tax policy, that such monies should not be subject to taxation when those contributions are paid out in the form of a lump sum payment. Thus, if it is treated as a non-taxable receipt in the U.S., then it is understandable why, as a matter of treaty policy, the U.S. would seek to ensure that a lump sum pension payment remains exempt from taxation in Canada. That in my view is the true purpose underlying Paragraph 1 of Article XVIII.

The numerical example goes on to provide that the first $5000 of a $10,000 lump sum payment represents a return of capital. In the circumstances it is reasonable to assume that the exclusion from gross income will be effected by permitting the taxpayer to deduct $5000 from the $10,000 that would be included in his or her gross income. That assumption is supported by the agreed statement of facts which refers to the “total taxable amount of the lump sum distribution” being allowed as a deduction from the taxpayer’s income: see subsection 1(h) of the Agreed Statement of Facts and Law.

The numerical example also provides that the amount of the lump sum payment which is excluded from taxable income cannot be increased by factoring in a personal allowance which is also deductible from gross income. Thus, for example, if the U.S. permitted a $2000 personal deduction in addition to the $5,000 exclusion, a resident taxpayer of Canada could not maintain that $7000 is tax exempt in Canada. The proper amount remains $5000, even though under U.S. tax law the taxpayer might be required to pay tax on only $3000. On the other hand, Canada would be entitled to tax the $5000 which is non- exempt, while providing a tax credit for any taxes paid in the U.S.

Within the above context, and applying the reasoning of the Tax Court Judge, it follows that a taxpayer would be unable to claim that the first $5000, which is excluded from taxable income in the U.S., is exempt from taxation in Canada because that itemized deduction qualifies as a personal allowance. Clearly, such a conclusion runs contrary to the very purpose underlying Paragraph 1 of Article XVIII, which is to ensure that any portion of a lump sum pension payment which is exempt from taxation in one Contracting State is exempt in the other. Accordingly, the conclusion that itemized deductions qualify as personal allowances must be rejected. This conclusion leads me to the third issue and the one ardently pursued by the Minister before this Court.

The Minister’s central submission is that the structure of Paragraph 1 of Article XVIII is such that the tax status of the lump sum payment in the U.S. must be determined on the basis of “an application of the U.S. tax law in its ordinary application without taking into account personal choices one may make under that domestic law”. Specifically, the Minister argues that the Convention refers to the tax status of an amount as if the taxpayer were a resident of the U.S. According to the Minister, this is a hypothetical situation and, therefore, one cannot take into account what the taxpayer personally would have done were he or she a resident of the U.S. That is to say, a particular tax status which does not arise unless the taxpayer elects to take it cannot be considered an ordinary application of U.S. tax law for the purposes of determining whether the exemption in Article XVIII of the Convention applies.

On reflection, the Minister’s position can be restated in at least one of two ways. First it could be said that the deduction or exclusion must be available as a matter of right and not election. Alternatively, the Minister’s position can be reduced to the simple proposition that Paragraph 1 of Article XVIII speaks to an amount that would be excluded from taxable income in the U.S. and not an amount that could be excluded. At first blush, one cannot deny that a substantive difference exists between the meaning of the words would and could. On the other hand, I am reluctant to embrace a literal reading of a text when no explanation was forthcoming which might explain the reason underlying the decision to deny an exemption in cases where the taxpayer must make an election before an amount is excluded from taxable income.

From the taxpayer’s perspective it is not a question of whether the lump sum payment would or could be excluded from gross income. As a matter of fact it was excluded, even if that exclusion is attributable to an election on his part. In my opinion, however, there is a rational basis which explains why the word would was employed in Paragraph 1 rather than the word could. That rational basis is found in the purpose underlying Paragraph 1. Once it is accepted, the Minister’s argument is complete.

As discussed earlier the purpose underlying Paragraph 1 of Article XVIII is to ensure that any portion of a lump sum payment which is exempt from taxation in the U.S. remains exempt in Canada. Thus, the question to be addressed is whether any part of the lump sum received by the taxpayer would under U.S. law be excluded from taxable income had he been a resident thereof during the 1989 taxation year. That is to say, for example, does any portion of the pension represent a return of capital? On the facts of this case the answer is no. Indeed, the entire lump sum payment was taxable under U.S. law. Although a deduction from gross income was available to the taxpayer, its purpose was to enable the taxpayer to have that amount taxed under a different (non-standard) regime so as to take advantage of the ten-year averaging rules.

In effect, the taxpayer seeks to establish that the purpose of Paragraph 1 of Article XVIII is to ensure that an amount remains exempt from taxation in one Contracting State (Canada) because it could be subject to a lower rate of tax in the other (U.S.). To achieve such a result one has to distort the ordinary meaning of Paragraph 1 and, in particular, the meaning attributable to the term would. This is but one instance in which the plain or literal meaning of a word and its ordinary or contextual meaning are in harmony. The Technical Explanation enables us to reach that conclusion by appreciating the underlying purpose of Paragraph 1. Against this background, one must conclude that the lump sum payment received by the taxpayer is not exempt from taxation in Canada and therefore the Minister’s reassessment must stand.

6. Conclusion

For the above reasons, the appeal should be dismissed with costs.

Appeal dismissed.