RECENT COURT DECISIONS

Transcription

1 RECENT COURT DECISIONS Heather DiGregorio Burnet, Duckworth & Palmer LLP Calgary Dan Jankovic Blake, Cassels & Graydon LLP Calgary 2015 Prairie Provinces Tax Conference

2 2

3 3 RECENT COURT DECISIONS For the 2015 Prairie Provinces Tax Conference, we have selected a number of recent decisions that deal with issues such as interest deductibility, taxation of derivatives, de facto and de jure control and reduction of a taxpayer s refundable dividend tax on hand balance. Of course, it is always a subjective exercise when choosing cases to discuss at a conference but we hope that the following summary will provide practitioners certain insights and at least several take-aways to keep in mind going forward. The selected cases are: I. The TDL Group Co. v. The Queen 1 II. George Weston Limited v. The Queen 2 III. McGillivray Restaurant v. The Queen 3 and Kruger-Wayagamack v. The Queen 4 IV. Presidential MSH Corporation v. The Queen 5 and Nanica Holdings Limited v. The Queen 6 I. The TDL Group Co. v. The Queen Generally, for interest to be deductible under subparagraph 20(1)(c)(i), interest must be, among other things, 7 paid in the year or payable in respect of the year on borrowed money used for the purpose of earning nonexempt income from a business or property. The issue in this case focused on the nature and scope of the income-earning purpose test in the subparagraph, and was whether the deduction of interest by The TDL Group Co. ( TDL ) on certain funds TDL borrowed from its shareholder satisfied that purpose test. Facts The relevant transactions can be summarized, and chronologically divided, as follows: a. March Transactions 1. Before March 18, 2002, Wendy s International Inc. ( Wendy s ), the ultimate parent of the group, loaned $234,000,000 (US$147,654,000) to its U.S. subsidiary, Delcan Inc. ( Delcan ) at an interest rate of 7 percent. 2. On March 18, 2002, Delcan loaned the same amount to TDL at a rate of percent On March 26, 2002 TDL used the funds received from Delcan to acquire 1,840 additional common shares in its wholly-owned U.S. subsidiary, Tim Donut U.S. Limited, Inc. ( Tim s US ) TCC 60 [hereafter referred to as TDL]. The case is under appeal to the Federal Court of Appeal. Unless stated otherwise, all statutory references in this paper are to the Income Tax Act (Canada) (the Act ) TCC 42 [hereafter referred to as Weston] TCC 357 [hereafter referred to as McGillivray] TCC 90 [hereafter referred to as Kruger] TCC 61 [hereafter referred to as Presidential] TCC 85 [hereafter referred to as Nanica]. 7 TDL, at paragraph 11. As noted by Justice Pizzitelli, the Supreme Court of Canada held in Shell Canada Ltd. v. R., [1999] 3 SCR 622 (SCC), that paragraph 20(1)(c) has four elements: (1) the amount must be paid in the year or be payable in the year in which it is sought to be deducted; (2) the amount must be paid pursuant to a legal obligation to pay interest on borrowed money; (3) the borrowed money must be used for the purpose of earning non-exempt income from a business or property; and (4) the amount must be reasonable, as assessed by reference to the first three requirements. 8 The loan receivable was subsequently assigned to another affiliate in the group.

4 4 4. On March 27, 2002, Tim s US made an interest-free loan to Wendy s, evidenced by a promissory note (the Note ). 9 b. June to November Transactions 5. In June of 2002, Tim s US incorporated a new U.S. subsidiary, Buzz Co. 6. Tim s US assigned the Note owing by Wendy s to Buzz Co. as payment for its subscription for shares in Buzz Co. 7. Buzz Co. issued a demand for payment on the Note to Wendy s. 8. On November 4, 2002, Wendy s repaid the Note in full by issuing a new promissory note to Buzz Co. for the same amount bearing an interest rate of 4.75 percent (the New Note ). In respect of its 2002 taxation year, pursuant to subparagraph 20(1)(c)(i), TDL deducted interest (in the amount of $10,094,856) on the funds it borrowed from Delcan. The Minister disallowed the interest deduction on the basis that the borrowed funds were not used by TDL for the purpose of earning income from a business or property (i.e., from the additional shares TDL acquired in Tim s US). The Minister denied the interest deduction for the approximately 7 month period ( Period ) during which the Note from Tim s US to Wendy s was non-interest bearing; i.e., the Minister allowed the interest deduction after the Note was replaced with an interest bearing New Note. Issue The narrow issue considered by Justice Pizzitelli was whether TDL s deduction of interest on the funds it borrowed from Delcan satisfied the purpose test in subparagraph 20(1)(c)(i). The parties did not dispute the direct use of the borrowed funds that use being the acquisition of additional shares in Tim s US. Decision Justice Pizzitelli of the Tax Court of Canada agreed with the Minister and disallowed TDL s deduction of interest. The trial judge began his decision by setting out a two part test when determining whether borrowed money had been used for the purpose of earning non-exempt income from a business or property: one must first identify the use of the borrowed money and then its purpose. 10 Since the use part of the test was not at issue, the decision focused on the purpose part of the test. a. The Purpose Test In explaining the purpose test, Justice Pizzitelli relied 11 on the Supreme Court of Canada s decision in Entreprises Ludco ltée c. Canada, 12 wherein the Supreme Court held at paragraph 55: the requisite test to determine the purpose for interest deductibility under s. 20(1)(c)(i) is whether, considering all the circumstances, the taxpayer had a reasonable expectation of income at the time the investment was made. [Emphasis added] Therefore, for TDL to be able to deduct the interest expense at issue, TDL had to demonstrate that, considering all the circumstances, TDL had a reasonable expectation, from an objective point of view, to earn income at 9 The evidence at trial suggested that the Note was originally intended to be interest bearing. However, the Note ended up being non-interest bearing at the time of issuance because of concerns that an interest bearing Note would have on state taxes in the U.S. and the thin capitalization and foreign accrual property income rules in Canada. 10 TDL, at paragraph Ibid., at paragraph SCC 62 [hereafter referred to as Ludco].

5 5 the time TDL acquired additional shares in Tim s US. The meaning and scope of certain of these elements are analyzed next. 1. All the Circumstances The Tax Court decided that the phrase all the circumstances has a broad meaning. Accordingly, the Court held that, in determining existence of an income-earning purpose in TDL s acquisition of the additional shares in Tim s US, the Court was not precluded from examining, inter alia, any series of transactions related to such acquisition, the indirect and ultimate use of the funds by Tim s US, or any other relevant factor Income Justice Pizzitelli held that income in subparagraph 20(1)(c)(i) refers to gross (not net) income, including capital gains or dividend income derived from direct or indirect uses of the money invested in shares. 14 Accordingly, TDL had to demonstrate that its acquisition of the additional shares in Tim s US could be expected to create or increase the chances for dividends or at least an increase in the value of its Tim s US shares. 15 b. Application of the Purpose Test The Tax Court held that TDL was not entitled to deduct interest on the borrowed funds pursuant to subparagraph 20(1)(c)(i) because TDL did not meet the income earning purpose test in that subparagraph. The Court found that TDL did not have a reasonable expectation of earning income of any kind, directly or indirectly 16 from its acquisition of the additional shares of Tim s US at the time of such acquisition on March 26, Justice Pizzitelli considered the following facts and findings, inter alia, in reaching his decision: 1. There was no reasonable prospect, on the facts, of TDL earning income in the form of dividends from the additional shares of Tim s US purchased by TDL. (i) (ii) (iii) (iv) (v) Tim s US had been a wholly-owned subsidiary of TDL for 4 years and, during that time, Tim s US had sustained substantial operating losses. Given its financial situation, Tim s US was not in a position to pay any immediate or short term dividend during the seven month Period during which the non-interest bearing Note was intended to be and was outstanding. The corporate group had a policy that dividends would not be paid out until all capital expenditures were funded. On this basis, dividends were not expected to be paid out until at least The ten year corporate plan included a line item for dividends and indicated that no dividends were to be paid. There is no mention of dividends in the tax planning documents or in the director s resolutions of TDL or Tim s US. Although dividends were in fact paid from 2007 to 2012, the Tax Court emphasized that this only occurred after the Tim Hortons group was spun out of the Wendy s group, and that no evidence was lead to suggest that these dividends were in the cards at the time TDL s subscription for the additional shares of Tim s US TDL, at paragraphs 26 and Ibid., at paragraph Ibid., at paragraph Ibid., at paragraph Ibid., at paragraph 31 (subparagraphs 1-5).

6 6 2. There was no credible evidence that any portion of the subscription funds invested in Tim s US was used or was intended to be used for a purpose other than to provide an interest-free loan to Wendy s. (i) (ii) For example, TDL director s resolution stated that the funds were expected to be used by Tim s US for future capital expenditures and repayment of debt, thereby suggesting that TDL s funds were intended to create wealth through the accumulation of capital in Tim s US. However, no direct capital expenditures were made and no repayment of debt was made by Tim s US as all the funds were lent to Wendy s on an interest-free basis the day after Tim s US received them from TDL. Further, director s resolution of Tim s US from the same date referred to Tim s US indebtedness to Wendy s (in the amount of $50,000) and authorized Tim s US to lend the subscription funds to Wendy s. Again, no debt payment was made and the funds were simply lent on an interest-free basis. Interestingly, even though both resolutions were approved on the same day, and with certain directors present at both meetings approving them, the resolution of Tim s US does not refer to any capital expenditures mentioned in the resolution of TDL There was no evidence of intention to charge interest on the loan to Wendy s. As stated by the Tax Court, if interest had been charged, we would not be here today. 19 Essentially, the Tax Court was not convinced, on the facts, that the subscription funds Tim s US received from TDL were used, or were intended to be used, for any purpose other than to immediately loan such funds to Wendy s on an interest-free basis. Discussion Practitioners should be mindful of the following points arising from the conclusions reached by the Tax Court: 1. For interest to be deductible under subparagraph 20(1)(c)(i), the provision requires identification of the use of the borrowed funds and then the purpose of the borrowed funds. 2. The use part of the test is ongoing (year by year) and ascertains the eligible, direct use of the borrowed funds. 3. The purpose part of the test is applied at the time an investment is made and takes into account all the circumstances in determining whether a taxpayer has a reasonable expectation of income. 4. To minimize disputes with the CRA in similar circumstances, and to demonstrate existence of an incomeearning purpose, consider charging interest on a loan or subscribing for dividend paying shares. 20 As underlined by Justice Pizzitelli, had interest been charged in the present case, TDL would not have appeared before the Tax Court. Practitioners should also note that the CRA s recent Income Tax Folio, S3-F6-C1: Interest Deductibility, indicates that it is conceivable that the CRA may allow the deductibility of interest in certain circumstances where, for example, a corporation is silent with respect to its dividend policy: Where an investment does not carry a stated interest or dividend rate, such as some common shares, it is necessary to consider whether the purpose test is met. Generally, the CRA considers interest costs in respect of funds borrowed to purchase common shares to be deductible on the basis that at the time the shares are acquired there is a reasonable expectation that the common shareholder will receive dividends. However, it is conceivable that in certain fact situations, such reasonable expectation would not be present. If a corporation has asserted that it does not pay dividends and that 18 Ibid., at paragraph 31 (subparagraph 8). 19 Ibid., at paragraph 31 (subparagraph 10). 20 For example, in this case the CRA accepted the very nominal spread of 0.125% between the loan issued by Wendy s to Delcan and the loan issued by Delcan to TDL. See the March Transactions described in Facts above.

7 7 dividends are not expected to be paid in the foreseeable future such that shareholders are required to sell their shares in order to realize their value, the purpose test will not be met. However, if a corporation is silent with respect to its dividend policy, or its policy is that dividends will be paid when operational circumstances permit, the purpose test will likely be met. Each situation must be dealt with on the basis of the particular facts involved. [emphasis added] 5. Evidence matters! As seen in this case, a Court can examine relevant corporate resolutions and other documents. For such evidence to be credible, what is stated in the resolutions and documents should reflect what actually happens. Since this case is under appeal, it would be inappropriate to provide additional take-aways until the Federal Court of Appeal renders its decision. However, for the time being, it is useful to make some observations that hopefully will be considered by the appellate court. 1. The Tax Court emphasized that the income-earning purpose test had to be applied at the time, and not after, TDL subscribed for the additional shares of Tim s US. On this basis, it should not matter whether down the line income is in fact earned. Interestingly, the CRA allowed the deduction of interest after Wendy s repaid its interest-free Note to Buzz Co. by issuing the interest bearing New Note; i.e., the CRA allowed the deduction of interest after approximately seven months had passed following the acquisition of the additional shares, which would suggest that the CRA engaged in an ongoing examination of the purpose of the investment. Since the purpose test is to be applied at the time of the investment, was the CRA s position consistent with the conclusion reached by the trial judge? 2. It should be recalled that the Supreme Court of Canada noted in Ludco, at paragraph 50, that nothing in the text of [subparagraph 20(1)(c)(i)] indicates that the requisite purpose must be the exclusive, primary or dominant purpose, or that multiple purposes are to be somehow ranked in importance in order to determine the taxpayer s real purpose. Therefore, it is perfectly consistent with the language of s. 20(1)(c)(i) that a taxpayer who uses borrowed money to make an investment for more than one purpose may be entitled to deduct interest charges provided that one of those purposes is to earn income. [emphasis added] Therefore, the finding of one or even ancillary income earning purpose suffices in the context of subparagraph 20(1)(c)(i). However, the Tax Court in TDL determined, on its interpretation of the facts, that the subscription funds Tim s US received from TDL were not used, and were not intended to be used, for any income earning purpose (i.e., for any purpose other than to immediately loan such funds to Wendy s on an interest-free basis). This was the Court s finding despite TDL s receipt of dividends from 2007 to Interestingly, while rejecting that such dividends were evidence of an income earning purpose, the Court held that, in determining existence of an income earning purpose in TDL s acquisition of the additional shares in Tim s US, the Court was not precluded from taking into account any series of transactions related to such acquisition (including the indirect or ultimate use of the funds) and any other relevant factor. 3. Lastly, it appears the Tax Court would permit the deduction of interest even where non-dividend paying shares are acquired on the basis that income from property in subparagraph 20(1)(c)(i) includes capital gains. However, subsection 9(3) provides that, in the Act, income from a property does not include any capital gain from the disposition of that property. It will be interesting to see what the Federal Court of Appeal decides on appeal of the Tax Court s decision. II. George Weston Limited v. The Queen This case dealt with the treatment of a hedging gain and questioned the merits of the CRA s administrative position on the taxation of derivatives. Facts George Weston Limited ( GWL ) is a Canadian publicly traded corporation and the parent holding company of subsidiary corporations inside and outside Canada. The subsidiaries various food processing and food

8 8 distribution companies are held directly and indirectly by GWL. A significant portion of the GWL corporate group s assets and businesses are located in the United States ( US ) and utilize US currency (referred collectively to herein as USD Operations ). In 2001, the GWL corporate group acquired the US-based bakery business Bestfoods Baking ( Bestfoods ) through its subsidiary Weston Acquisitions Inc. This acquisition significantly increased the GWL corporate group s existing net investments in USD Operations from approximately US$800 million to over US$2 billion. The Bestfoods acquisition was financed entirely by debt, through loans from Canadian banks to GWL. GWL invested the borrowed funds in its subsidiaries, including Weston Acquisitions Inc., which in turn acquired Bestfoods. As a result of the significant investment in USD Operations represented by the Bestfoods acquisition, the consolidated financial statements of GWL became highly sensitive to CAD and USD exchange rate fluctuations. Further, at the time of the acquisition of Bestfoods, the Canadian dollar ( CAD ) was at a historic low against the US dollar ( USD ). a. Exposure to Exchange Rate Fluctuations Pursuant to generally accepted accounting principles ( GAAP ), GWL reported, in CAD, the combined assets and liabilities of its controlled subsidiaries in consolidated financial statements. The equity section of the consolidated financial statements included the currency translation account or CTA. The CTA in GWL s statements reflected the value of GWL s net investments in USD Operations translated into CAD. Therefore, when the CAD appreciated relative to the USD, GWL s consolidated equity decreased, and when the CAD depreciated, GWL s consolidated equity increased. Because the CAD was at historic lows at the time of the Bestfoods acquisition in 2001, GWL anticipated that, over time, the CAD would appreciate substantially relative to the USD. This would have a number of adverse effects for GWL: its consolidated equity would decrease, and its debt to equity ratio which had exceeded its corporate policy of 1:1 as a result of the Bestfoods acquisition would worsen. These results could in turn affect GWL s credit rating and cost of capital, cause it to violate loan covenants, or encourage investors to sell its stock. b. Currency Swaps To circumvent the currency risk, GWL decided to hedge against it by entering into cross-currency basis swap contracts ( swaps ), for terms of mostly years, with various counterparties. The notional value of the swaps closely approximated GWL s total net investments in the USD Operations (i.e. USD $2 billion). The periodic payments made pursuant to the swaps (either by GWL to the counterparties or vice versa) varied inversely with, and therefore offset, changes in the CAD-translated value of GWL s net investments in USD Operations. 21 As a result, the swaps functioned to stabilize the CTA and consolidated equity of GWL. In addition, the swaps were entered into by GWL (and not its subsidiaries) because (a) the counterparties wanted to deal with GWL, and (b) GWL had a higher credit rating than its subsidiaries, which reduced the cost of swaps. c. Termination of the Swaps By 2003, the CAD had appreciated to what GWL determined to be a multi-year high against the USD. Based on this assessment, GWL determined that its currency risk had sufficiently decreased such that hedging via the swaps was no longer necessary. Further, GWL had refinanced or repaid its initial Bestfoods acquisition financing. As a result, GWL s debt to equity ratio was expected to fall within the accepted 1:1 ratio. Finally, GWL needed funds to repurchase shares from its majority shareholder and for other activities. Each of these considerations led GWL to terminate the swaps in If CAD appreciated, the increase in the value of the swaps would offset the decrease in the CAD translated value of GWL s net USD investments on GWL s consolidated balance sheet. If CAD depreciated, the decrease in the value of the swaps would offset the increase in the CAD translated value of GWL s net USD investments on GWL s consolidated balance sheet.

9 9 Because the CAD had appreciated relative to the USD between 2001 and 2003, the counterparties made net principle repayments of totalling CAD $316,932,896 to GWL. In its 2003 income tax return, GWL treated the CAD $316,932,896 as being on account of capital and reported a taxable capital gain of CAD $158,466,448. The Minister reassessed GWL on the basis that the CAD $316,932,896 was on income account. Issue The issue was whether the gain realized by GWL upon termination of its currency swaps was on income or capital account. CRA s Administrative Position The CRA s administrative position regarding whether the gains or losses from a derivative are treated on income or capital account is articulated in several CRA rulings, including in CRA Document No I7. 22 The CRA Ruling describes the linkage test and notes that, in the CRA s view, receipts from the closing out of a derivative will be treated as being on capital account for income tax purposes only if it can be shown that the derivative (a) is a hedge, and (b) linked to an underlying transaction that is the purchase or sale of a capital asset, the repayment of a debt denominated in a foreign currency, or the investment of idle capital funds. According to the CRA, if the derivative is linked to an asset or liability that the taxpayer has no intention of disposing of, the derivative will not be sufficiently linked to a capital transaction and, therefore, any gains or losses arising from it will be considered by the CRA to be on account of income. 23 In addition, the CRA s linkage test requires that the capital transaction or debt obligation be entered into by the taxpayer that enters the forward contract. Minister s Position at Trial In accordance with the aforementioned CRA Ruling, the Minister took the position that the Bestfoods acquisition was not part of a transaction as contemplated by the CRA s linkage test because GWL had not disposed of and had no intention of disposing of Bestfoods at the time the swaps were entered into. 24 According to the Minister, GWL also was required to hold Bestfoods directly to satisfy the CRA s linkage test. In sum, the Minister argued that the gains from the swaps were on income account on the basis that (a) the swaps were not entered into as a hedge, and (b) GWL could not establish sufficient linkage to a capital transaction denominated in a foreign currency that it entered into on its own account. Appellant s Arguments Conversely, GWL argued that (a) the swaps were entered into as a hedge, and (b) the item that prompted the hedge, namely GWL s investment in USD Operations, was capital in nature. According to GWL, the proceeds from terminating the swaps should accordingly be treated as being on capital account. At trial, GWL provided ample evidence to demonstrate that the swaps were entered into as a hedge. Such evidence included: 1. the formal GWL corporate policy against speculating on derivatives (i.e., GWL was not in the business of acquiring and terminating swaps); 2. annual reports that publically confirmed the purpose of the swaps was a hedge; 3. the fact that the notional value of the swaps was determined based on the value of USD investments subject to currency risk (i.e. USD $2 billion); 4. the fact that, from an accounting perspective, the swaps were treated and properly recorded as a hedge in GWL s consolidated financial statements in accordance with GAAP; and that 22 See, for example, CRA Document No I7, Derivatives Income or Capital, dated April 15, 2010 [hereafter referred to as the CRA Ruling ]. 23 On the basis that the gain or loss results from speculation in the derivatives market or is part of the ordinary business of the taxpayer. 24 The Bestfoods assets were sold in 2009 by an indirect subsidiary of GWL.

10 10 5. the swaps were only terminated when GWL concluded that its currency risk was waning and its debt to equity ratio could return to desired levels independently of the swaps. GWL also argued that the presence of an underlying transaction, as required by the CRA s linkage test, is not a prerequisite for the gain or loss on disposition of a derivative to be treated as capital. As long as the item that prompted the taxpayer to enter into the derivative contract was capital in nature, so too should the gain or loss on disposition be treated as capital. The item that prompted GWL to enter into the swaps and thereby hedge against the risk it was exposed to was its USD Operations, primarily Bestfoods. As a holding company, GWL argued that it held its subsidiaries, including Bestfoods, as a capital investment. GWL financed its subsidiaries to acquire the USD Operations through loans and/or equity investments, i.e., outlays that were capital in nature. Further, Bestfoods in particular was acquired with the intention of holding it long-term. 25 GWL accordingly submitted that the gains on the termination of the swaps were on capital account. Decision The Tax Court of Canada agreed with the appellant s position described above and held that GWL s early termination of the swaps resulted in a capital gain, thereby rejecting the administrative views articulated in the CRA Ruling. a. The swaps were a hedge In ascertaining the meaning and scope of a hedge, Justice Lamarre of the Tax Court first noted that the word is not defined in the Act except in the context of weak currency debts in subsection 20.3(1). The Court then considered the usefulness of well-accepted business and accounting principles in the present circumstances. While recognizing that such principles play a subsidiary role to clear rules of law, the Court held that it would be unwise for the law to eschew the valuable guidance offered by well-established business principles where statutory definitions are absent or incomplete. 26 As a result, Justice Lamarre decided that accounting realities, such as the requirement for GWL to report consolidated financial statements in CAD and the influence of CTA on GWL s consolidated equity, must be taken into account. This conclusion was important because the Minister had argued that GWL s foreign exchange translation risk existed only because of the GAAP requirements that the value of the net assets of the subsidiaries be translated into CAD for consolidated reporting purposes. Justice Lamarre noted that these accounting realities were important to consider and held that, regardless of the fact that GWL s currency risk was only reportable as a function of the CTA and GAAP, the currency risk faced by GWL was real. The Court generally described hedging as the off-setting of a financial risk and held that GWL demonstrated that the swaps were entered into as a hedge and not with the intent to speculate. 27 In support of this conclusion, the Court highlighted the significance of the Bestfoods acquisition and the currency risk that it created, noting that the transaction represented a 26% increase in GWL s total assets, a doubling of its total indebtedness, and more than a 200% increase in USD investments. 28 b. Direct Ownership is Not Required The trial judge next considered the direct ownership aspect of the CRA s linkage test, holding that the swaps entered into by GWL constituted a hedge despite the fact that GWL s subsidiary acquired Bestfoods and conducted USD Operations. In support of this finding, Justice Lamarre drew a parallel to the Neonex case 29 wherein the Federal Court of Appeal found that a loan made solely for the purpose of replenishing the working 25 With the exception of one component of the business that was intended to be sold. Again, this was in line with GWL s corporate history of holding Loblaws and its US baking assets for the long term. 26 Weston, at paragraph 69, citing Placer Dome Canada Ltd. v Ontario (Minister of Finance), [2006] 1 SCR 715 (SCC) which in turn cites Canderel Ltd. v Canada, [1998] 1 SCR 147 (SCC), at paragraph Ibid., at paragraph Ibid., at paragraph Neonex International Ltd. v The Queen, [1978] CTC 485 (FCA) [hereafter Neonex].

11 11 capital of a subsidiary which had acquired control of another company was a capital transaction. By way of summary, in Neonex the parent had borrowed USD funds and lent the funds to its subsidiary. When the parent repaid its USD loan, it made a foreign exchange gain which was determined to be on capital account. As part of this analysis, the Federal Court of Appeal attributed the capital character of the subsidiary s capital asset to the parent company s investment in its subsidiary. 30 The circumstances were substantially similar in the context of GWL, which made loans to its subsidiary to acquire Bestfoods, and entered into swaps in consultation with, and on behalf of, its subsidiaries to protect the equity of the whole GWL corporate group. As foreign exchange fluctuations affected GWL s own capital structure and not just that of its subsidiaries, the fact that GWL did not directly own the item that created the risk did not change the eventual conclusion that the hedging gains were appropriately characterized as capital. c. Characterization of the Hedging Gain To determine whether an underlying transaction must exist for a hedging gain or loss to be on account of capital, as required by the CRA s linkage test, Justice Lamarre considered the case law relied on by the Minister in support of the CRA s test. The analyses of Salada Foods Ltd. v. The Queen 31 and Shell Canada Ltd. v. Canada 32 are of most assistance to explain the Court s reasoning. 33 The Minister first relied on Salada wherein the taxpayer derived a profit from the purchase and sale of foreign exchange through a forward sale contract with a bank. Salada argued that the profit was on capital account because the forward contract was entered into for the purpose of protecting its investment in United Kingdom subsidiaries from currency risk. The Federal Court in Salada rejected this argument because Salada failed to establish a link or relationship between the gain from the forward sale contract and any loss due to devaluation of the British pound. Moreover, Salada admitted that the derivative transaction was speculative. As a result, the Federal Court held that the gain was on income account. Justice Lamarre in Weston noted that the Federal Court in Salada never states that the company would not have been able to hedge its capital asset (i.e., investments in the United Kingdom subsidiaries) but, rather, that the facts did not support that there was a hedge in that case. 34 In Shell, the company entered into a foreign currency debt obligation in a weak currency. The borrowed funds were used for capital purposes. To hedge its exposure to currency risk upon repayment, Shell entered into a forward exchange contract in the same amount as the debt obligation. Upon the conclusion of these transactions, Shell realized a gain on the derivative which was characterized by the Supreme Court as being on capital account. According to the Minister, the foreign exchange gain could only be characterized as being on capital account because there was an underlying capital transaction (i.e., the capital debt obligation 35 ). GWL disagreed with the Minister s interpretation, noting that the Supreme Court did not say in Shell that the derivative must necessarily be linked to a separate or underlying transaction. Instead, the Supreme Court held that the characterization of the hedging gain depended on the characterization of the item to which the hedge related in this case, the debt obligation. Because the debt obligation was entered into for capital purposes, so too was the gain on the forward exchange contract. Justice Lamarre agreed with GWL s interpretation of Shell and decided that in order to characterize the proceeds from a derivative transaction, one needs to identify the underlying item that created the risk (in the Shell case, the 30 Weston, at paragraph 44. In Neonex, the Federal Court of Appeal held at paragraph 19: the only realistic inference to be drawn is that the borrowing was from beginning to end to finance a capital acquisition which in the event was abortive, and, therefore, the foreign exchange gain arose as an incident relating to the repayment of a loan made for a capital purpose and not one made as part of its subsidiary financing operations which may be of an income earning character DTC 6171 (FCTD) [hereinafter Salada ]. 32 [1999] 3 SCR 622 (SCC) [hereinafter Shell ]. 33 Note that the following cases were also discussed: Atlantic Sugar Refineries Ltd. v Minister of National Revenue, [1949] SCR 706 and Tip Top Tailors Ltd. v Minister of National Revenue, [1957] SCR 703 (dealing specifically with the purchase or sale of commodities or supplies such that their relevance was limited); Saskferco Products ULC. v The Queen, 2008 FCA 297; and Ethicon Sutures Ltd. v The Queen, 85 DTC 5290 (FCTD). 34 Weston, at paragraphs Ibid., at paragraph 80. The debt obligation consisted of debenture agreements that provided Shell with working capital for a five-year term.

12 12 debt obligation) to which the derivative relates (which item does not necessarily need to be a transaction). 36 Tax Court held: The What is important is to identify the risk to which the derivative transaction is related and to determine whether the related item at risk (be it a debt obligation or foreign investments) is capital or income in nature. 37 In sum, the trial judge concluded that, from a commercial perspective, GWL would not have entered into the swaps but for the Bestfoods transaction. That is, the item at risk to which the swaps were related was Bestfoods and the USD Operations. Because GWL s indirect investment in USD Operations, just like its direct investment in its subsidiaries, was capital in nature, the gains realized on the swaps were properly characterized as being on capital account. Discussion The key take-away from the Tax Court s decision in Weston is this: in characterizing the proceeds from a derivative transaction, it is important to first identify the risk to which the derivative transaction relates, and then determine whether the underlying item at risk is on capital or income account. Since the decision has not been appealed, taxpayers may want to revisit their characterization of hedging transactions for Canadian tax purposes in light of this decision. It is also important to emphasize that the Tax Court outright rejected the positions articulated in the CRA Ruling. Indeed, the Court expressly states that the CRA Ruling has no legal basis and is a wrong interpretation of the case law. 38 One would expect the CRA to soon update its administrative position given the findings of the Court. The following paragraphs set out certain elements of the CRA s linkage test and note the corresponding aspects of the Weston decision that reject those elements. a. Underlying Transaction and Expected Disposition The CRA Ruling provides: In our view, in order for a forward contract to be a hedge for income tax purposes, the forward contract needs to be linked to a transaction (e.g., sale, repayment of debt), not an asset or liability. However, in our view, depending on the facts, a projected disposition of an asset may involve sufficient linkage. In our view, if there is no expected disposition of a subsidiary that is being hedged with a hedging contract, capital treatment is not available. 39 [emphasis added] In Weston, however, there was no underlying transaction linked to GWL s swaps. GWL intended to hold Bestfoods for the long term and did not anticipate any disposition of Bestfoods at the time it entered into the swaps. The trial judge agreed with GWL s argument that the underlying transaction requirement in the CRA linkage test was restrictive and not aligned with commercial realities. The Tax Court further agreed that on a proper interpretation of the case law, there must be an underlying item at risk, rather than a transaction, for which the derivative transaction is related. The gain or loss resulting from the derivative transaction will be on capital or income account depending on whether the underlying item is capital or income in nature. Indeed, Justice Lamarre notes that: In Shell, it was determined that hedge proceeds will be on capital account if the item being hedged is a capital item. The Court did not lay down a rule that would support the [Minister s] restrictive approach Ibid., at paragraph Ibid. 38 Ibid. 39 CRA Ruling, at Weston, at paragraph 97.

13 13 b. Direct Ownership of the Hedged Item The CRA Ruling provides: In our view, the legal entity should have a direct ownership of the underlying hedged item. From a separate legal entity perspective, the legal entity should have an underlying transaction exposed to foreign exchange rate fluctuations, otherwise, there is no offsetting position against which any of the gains and losses arising from the hedges could be matched. 41 [emphasis added] In Weston, GWL did not directly own the USD Operations, including Bestfoods. It therefore did not satisfy the requirement in the CRA s linkage test that the hedged item be owned by the same entity that enters into the hedging contract. As noted above, Justice Lamarre held that the swaps constituted a hedge for GWL despite the fact that the USD Operations being hedged against were indirectly owned by GWL. Despite indirect ownership of the USD Operations, foreign exchange fluctuations affected GWL s consolidated equity and its capital structure. Further, GWL had a higher credit rating than its subsidiaries and was acting in close consultation with them, as well as on their behalf, in order to protect the equity of the whole GWL corporate group. It was therefore appropriate for GWL to be the entity entering into the hedging contracts. c. Role of Intention The CRA Ruling provides: It is our opinion that the original stated intent does not govern the nature of a hedge for the entire term of the contract, particularly when the hedging relationship has ceased to exist before the contract matures. 42 In Weston, the Minister argued that, regardless of GWL s supposed intention to use the swaps as a hedge when it initially entered into them, such intention ultimately changed when GWL decided to prematurely terminate the swaps in According to the Minister, GWL had undertaken measures other than the swaps to bring its debt to equity ratio back to 1:1, and the GWL board of directors chose to terminate the swaps in order to use the cash for another purpose. The Minister also alleged that, when the swaps were terminated, Bestfoods became exposed to the same currency risk that the swaps were supposedly meant to hedge against. Therefore, according to the Minister, GWL s intention in 2003 changed to an adventure in the nature of trade because GWL was seeking to profit from the derivatives market. Justice Lamarre in Weston disagreed with the Minister s changed-intention argument, finding that GWL s decision to terminate the swaps was based on a re-evaluation of the very risks which had caused GWL to enter into the swaps in the first place. As these risks were no longer significant, it was reasonable for GWL to terminate the swaps. Further, there was no evidence to suggest that the termination was related to speculation or a change in the original intention from hedging to seeking to profit from the derivatives market. Arguably, the Tax Court does not reject intention as a relevant consideration when characterizing gains or losses from a derivative transaction. By stating that GWL s termination of the contracts was aligned with the taxpayer s stated intention to hedge, and with no evidence to the contrary, the trial judge suggests that there may be circumstances where the opposite was true and that such a change of intention may be relevant. However, there is insufficient discussion of this matter in the case to make a definitive statement in this regard. d. Distinctions between a hedge for accounting and for tax purposes In the CRA Ruling, a taxpayer inquired as to whether linkage could be established in circumstances equivalent to those faced by GWL. The taxpayer sought: Determination if it is possible to have sufficient linkage when the foreign exchange exposure exists only on the consolidated financial statements. Specifically, if consolidated financial statements are prepared using US dollar functional currency and the hedges are entered into by the Canadian parent to hedge net investments in Canadian subsidiaries, will capital treatment ever be appropriate? The legal entity financial statements of the Canadian parent for tax purposes are 41 CRA Ruling, at Ibid., at 5.

14 14 prepared using Canadian dollars, so for legal entity financial statement purposes there is no underlying hedged asset which has a foreign exchange risk. 43 The CRA Ruling notes that there is no underlying transaction in the above example and highlights the fact that hedge accounting for consolidated financial reporting is not determinative of the tax treatment of a hedge for separate legal entity tax reporting. The Tax Court in Weston agreed with the other Courts which have repeatedly held that accounting practices by themselves do not establish rules of law, and added that an accounting hedge may not be appropriate for tax purposes in the absence of correlation between the hedge transaction and the element of risk to be hedged. 44 However, Justice Lamarre also stated that it would be unwise for the law to eschew the valuable guidance offered by well-established business principles where statutory definitions are absent or incomplete, as is the case for the definition of hedge. 45 Accordingly, the trial judge found that the definition of hedging as understood under well-established accounting principles, including GAAP, is relevant. Having so found, the Tax Court concluded that GWL satisfied all accounting requirements for hedge treatment, including designating the swaps as a hedge in its consolidated financial statements in advance and keeping the swaps gains and losses closely correlated with the CTA gains and losses throughout the time the hedge was in place. 46 The trial judge also noted that GWL had a choice to implement hedge accounting and, once that choice was made, GWL had to, and did, comply with stringent GAAP rules. The fact that GWL reported the swaps as a hedge in its consolidated financial statements appears to have assisted the Court in reaching its decision. Therefore, while the distinction between a hedge for accounting and a hedge for tax purposes remains, in certain circumstances it may be appropriate to consider hedge accounting principles when characterizing the hedging gains or losses as being on capital or income account. III. McGillivray Restaurant v. The Queen and Kruger-Wayagamack v. The Queen The Tax Court of Canada has released two important cases in 2015 dealing with the concept of control under the Tax Act. In each case the judge approached the analysis differently, and they each came to a different conclusion on the control issue. Arguably each of the two cases came to the correct conclusion (at least with respect to the question of control) based on their individual facts. It should be noted, however, that the two cases are both currently under appeal to the Federal Court of Appeal. McGillivray Facts In McGillivray, the Tax Court was faced with deciding whether two corporations were associated for purposes of sharing the small business deduction. One corporation was owned by Mr. Howard ("Husbandco"), and the other corporation was majority-owned by his wife, Mrs. Howard 47 ("Wifeco"). Husbandco owned the franchises for two The Keg Restaurants, and Wifeco owned a franchise for a third The Keg Restaurant. The history of the restaurants was important in this case. Mr. Howard had worked at The Keg for twenty years prior to acquiring the three franchises in Husbandco. He had worked his way up from server to manager, and eventually he was offered three franchises of the restaurant chain. He also obtained restrictive covenants from The Keg, which was contractually obligated not to compete with him in the city of Winnipeg, nor to allow any other franchises to be sold in that city. The restaurants were successful, and Mr. Howard developed a plan to replace one of the restaurants that was operating in rented premises, with a new restaurant located on real estate owned by him. Mr. Howard was advised to hold the new restaurant in a separate corporation that was majority-owned by his wife. Thus, Mr. and Mrs. Howard established Wifeco for this purpose. 43 Ibid., at Weston, at paragraph 92, citing Saskferco Products ULC. V. The Queen, 2008 FCA Ibid., at paragraph 69 citing Canderel Ltd. v. Canada, [1998] 1 SCR 147, at para Ibid., at paragraph The ownership split was 76% owned by Mrs. Howard, and 24% owned by Mr. Howard.

15 15 Wifeco was majority owned by Mrs. Howard, but the facts implied that it was still very much Mr. Howard's business. Mr. Howard's understanding, one the one hand, was that the corporations were completely independent of one another. On the other hand, however, Mr. Howard did not need to get his wife's approval in matters involved running the restaurant and Wifeco. Mrs. Howard's duties are described as minimal mostly providing the occasional feedback to Mr. Howard, and arranging for the plants on the restaurant patio. In contrast, Mr. Howard was the sole director and officer of Wifeco, in addition to managing the restaurant. There was also a considerable degree of interdependence between Husbandco and Wifeco. The bank accounts were consolidated, and Wifeco made significant advances to Husbandco without interest, repayment terms, or security. Additionally, Wifeco guaranteed Husbandco's third party debt. There was also the fact that The Keg head office agreed to transfer the franchise agreement to Wifeco solely on the condition that Mr. Howard continue to manage and run the restaurant on the same basis as he had done with the previous restaurant. Issue The issue in the case was whether Wifeco was controlled, directly or indirectly in any manner whatever by Mr. Howard, such that Wifeco would be associated with Husbandco. Decision As with many cases where the question is whether two corporations are associated, the Tax Court jumped immediately into the law on de facto control. Interestingly, the Court took the opportunity to examine the case law that has developed over time with respect to the de facto control test, and identified two streams of interpretation that have emerged: one in which the Court is restricted to a narrow set of factors when determining if there is control, versus another in which the Court is allowed to examine the influence that a potential controller may have in a broader manner. By looking solely at the Silicon Graphics 48, Transport Couture 49, and Lenester Sales 50 cases, the Court felt that that the scope of what is to be considered was unclear. In Silicon Graphics, the Court of Appeal clearly stated that a controller must have a clear right and ability to influence the board of directors, or the shareholders that have the ability to elect the directors. On the other hand, in Transport Couture, the trial judge looked at the operational control, economic dependence and family relations of the parties. The Court then refers to a statement in Lenester which identifies some cases, such as Transport Couture, as taking a broader interpretation of the test. Ultimately, the Tax Court concludes that the Mimetix 51 and Plomberie 52 cases have settled the matter, and accepts that a broader examination of factors is the correct method. The Court wraps up the analysis by bringing it back to the Duha Printers 53 case, and states that the de facto control test is really just the search for effective control of the corporation. From there, the Tax Court looks to the facts of Husbandco and Wifeco and concludes that Mr. Howard was exercising de facto control over Wifeco. Given the facts of the case, it is not particularly surprising that the judge found de facto control to reside in Mr. Howard. However, what is really interesting about the case is the review of the case law to date, and the judge's recognition that it hasn't always been easy to determine what factors should be looked at when determining de facto control. In fact, it appears that over the years many judges have struggled with the de facto test, and how it is different that the de jure control test. The approach taken by the judge in the Kruger case effectively solves this problem, and arguably is one of the best approaches that have been espoused to date. 48 Silicon Graphics Ltd. v. R., 2002 FCA Transport M.L. Couture Inc. c. R., 2004 FCA Lenester Sales Ltd. v. R., 2003 DTC 997 (TCC). 51 Mimetix Pharmaceuticals Inc. v. R., 2003 FCA Plomberie J.C. Langlois Inc. c. R., 2006 FCA Duha Printers (Western) Ltd. v. R., 98 DTC 6334 (SCC).