Date: 20030305
Docket: A-24-02
Neutral citation: 2003 FCA 112
CORAM: STONE J.A.
BETWEEN:
NOVOPHARM LIMITED
Appellant
and
HER MAJESTY THE QUEEN
Respondent
Heard at Toronto, Ontario, on January 15, 2003.
Judgment delivered at Ottawa, Ontario, on March 5, 2003.
REASONS FOR JUDGMENT BY: ROTHSTEIN J.A.
CONCURRED IN BY: STONE J.A.
MALONE J.A.
Date: 20030305
Docket: A-24-02
Neutral citation: 2003 FCA 112
CORAM: STONE J.A.
BETWEEN:
NOVOPHARM LIMITED
Appellant
and
HER MAJESTY THE QUEEN
Respondent
REASONS FOR JUDGMENT
[1] There are four issues in this appeal from a decision of the Tax Court (2002 D.T.C. 1307):
1. was Novopharm Limited (Novopharm) entitled to interest deductions of $10,027,914 in its 1987 tax year and $9,579,540 in its 1988 tax year, pursuant to subparagraph 20(1)(c)(i) of the Income Tax Act, R.S.C. 1985, (5th Supp.) c. 1;
2. was Novopharm entitled to deduct a loan arrangement fee of $500,000 in its 1987 taxation year, pursuant to subparagraph 20(1)(e)(ii) of the Act;
3. was Novopharm entitled to deduct a consulting fee of $200,000 in its 1987 taxation year, pursuant to subsection 9(1) or was the deduction prohibited by paragraph 18(l)(a) of the Act; and
4. if Novopharm was entitled to the interest, loan arrangement and consulting fee deductions, pursuant to subparagraph 20(1)(c)(i), subparagraph 20(1)(e)(ii) and subsection 9(1) respectively, was it disentitled to the deductions pursuant to subsection 245(1) (S.C. 1970-71-72, c. 63) of the Act in force in 1987 and 1988 and since repealed (S.C. 1988, c. 55, s. 185(1))?
[2] Novopharm was reassessed by the Minister of National Revenue for the deductions claimed. Novopharm's appeal to the Tax Court was dismissed. This is the appeal from the Tax Court decision.
[3] Novopharm concedes that the transactions giving rise to the deductions claimed were solely tax avoidance transactions. At the end of all the transactions, Novopharm was in virtually the same position as it was before the transactions took place, except for the costs it incurred to enter into and complete the transactions.
[4] The approximately forty transactions created an interest deduction in the profitable Novopharm, while allocating the earnings from borrowed funds to a company, Royal Scot Resources Ltd., with accumulated non-capital losses and unused Canadian exploration and development expenses (collectively, losses) which offset the earnings the company received. The net result was the deduction of interest by Novopharm, with no liability for income tax on the earnings from the borrowed funds because they were allocated to Royal Scot whose losses offset the earnings.
[5] I cannot do better in describing the transactions than the learned Tax Court Judge and I adopt and set out his paragraphs 11 to 22 hereunder.
[11] On June 12, 1987, 722537 Ontario Inc. (537), 722538 Ontario Inc. (538), 722539 Ontario Inc. (539) and 540 were incorporated under the Business Corporations Act of Ontario. 537, 538 and 539 were incorporated as subsidiaries of Royal Scot, while 540 was incorporated as a subsidiary of 539. The same day, 537 and 538 entered into an agreement to create a limited partnership, Millbank [Limited Partnership]. 537 was the general partner, with a .01% interest, and 538 was the limited partner, with a 99.99% interest. 538 made a capital contribution of $20,000.
[12] On June 23, 1987, Millbank borrowed $193,913,043 from First Marathon Capital Corporation ("FMCC") at 11.50% per annum for a period of one year, maturing on June 23, 1988 ("loan #1"). In addition to the interest on loan #1, Millbank also obligated itself to pay a $500,000 loan arrangement fee to FMCC. It was a condition of loan #1 that Millbank lend the proceeds of loan #1 to First Marathon Inc. ("FMI"), FMCC's parent company, on the same day at 11.55% per annum for an identical period of time, in return for FMI's promissory note (the "FMI note"), and that the FMI note be pledged by Millbank to FMCC as security for loan #1. No loan arrangement fee was payable by FMI to Millbank. The terms of the FMI note entitled Millbank to demand prepayment of all the interest payable on it for the one-year term, and also that any such prepayment was to be applied in reduction of loan #1. To implement these transactions, FMCC issued a cheque to Millbank in the amount of $193,913,043 as the proceeds of loan #1, in return for Millbank's promissory note in the same amount, on the terms I have described. Millbank immediately endorsed this cheque in favour of FMI in return for the FMI note in that amount, on the terms described. Millbank immediately demanded prepayment of the interest on the FMI note, and received a cheque from FMI in the amount of $19,991,035, the discounted value of the future interest accruing on the FMI note from June 23, 1987 to June 23, 1988. Millbank immediately endorsed that cheque to FMCC to reduce the balance of loan #1 from $193,913,043 to $173,922,008, as it was required to do by the terms of the FMI note.
[13] On June 24, 1987, Royal Scot acquired 538's 99.99% limited partnership interest in Millbank for $20,000, which it paid for by way of a demand promissory note in that amount.
[14] On June 25, 1987, Millbank declared its first fiscal year end, reporting a net income for tax purposes of $19,381,440, consisting of the prepaid interest of $19,993,775, less the loan arrangement fee payable by Millbank to FMCC in the amount of $500,000, and two days' accrued interest of $109,539 on loan #1, and net of the loss for accounting purposes of $2,796. Of Millbank's net income for tax purposes of $19,381,440, 99.99%, or $19,379,502, was allocated to Royal Scot, and .01%, or $1,938, to 537. The amount which was allocated to Royal Scot was offset by the losses, and so attracted no income tax liability.
[15] On June 30, 1987, the following transactions took place.
(i) 539 acquired 537's .01% general partnership interest in Millbank for $1.00.
(ii) 540 acquired Royal Scot's 99.99% limited partnership interest in Millbank, for which it gave Royal Scot two non-interest bearing promissory notes in the amounts of $20,000 and $2,000,000.
(iii) Novopharm acquired all of the issued shares of 539 from Royal Scot for $10.00.
(iv) Novopharm acquired from 539 all of its shares in 540 for $10.00.
(v) Novopharm purchased from Royal Scot 540's promissory note in the amount of $2,000,000 by substituting its own promissory note of $2,000,000 for 540's note. Novopharm's note was also payable without interest but, unlike the 540 note which it replaced, was payable only if certain changes to the Act which would have prevented Novopharm from deducting the interest payable by it on loan #2 did not come into effect.
(vi) Novopharm subscribed for treasury shares of 540 for $20,000, and 540 then used the proceeds to pay its promissory note to Royal Scot in the same amount. Royal Scot endorsed the cheque from 540 to pay off its $20,000 promissory note owing to 538.
(vii) Novopharm purchased additional treasury shares of 540 for $500,000, and 540 used the proceeds to make an additional capital contribution to Millbank, which in turn used it to pay off the loan arrangement fee in that amount to FMCC which it had incurred with respect to loan #1.
(viii) Novopharm borrowed $173,922,008 from FMCC at 11.5%, maturing on June 23, 1988 ("loan #2"). It was a condition of this loan that Novopharm use the proceeds to purchase additional treasury shares of 540, which it did. 540 then used the proceeds of the share purchase to make a contribution of capital to Millbank.
(ix) In addition to the interest that was payable on loan #2, Novopharm paid FMCC a loan arrangement fee of $500,000 for loan #2.
(x) Novopharm also issued a promissory note to Westmorland Financial Service Inc. in the amount of $200,000. This promissory note was subject to the same condition relating to a possible amendment to the Act as Novopharm's $2,000,000 promissory note issued to Royal Scot.
(xi) the FMI note was pledged to FMCC by Millbank as security for loan #2.
[16] On August 10, 1987, Novopharm paid Messrs. Fogler, Rubinoff, $75,549.84 for their services in connection with these transactions. On August 13, 1987, Novopharm paid Laventhol & Horwath a fee of $200,000.
[17] The amendment to the Income Tax Act about which the parties were concerned did not occur, and so in January 1988, Novopharm paid $2,000,000 to Royal Scot and $200,000 to Westmorland Financial Services to discharge its obligations to them.
[18] As at June 23, 1988, the following amounts were owed on loan #1 and loan #2, and on the FMI note:
(i) FMI owed Millbank $193,913,043 as principal on the FMI note.
(ii) Millbank owed FMCC interest of $383,581 on loan #1.
(iii) Novopharm owed FMCC $193,539,458 on loan #2, made up of $173,922,008 principal and $19,617,450 interest.
[19] On June 23, 1988, both loan #2 and the FMI note matured, as a result of which the following events took place:
(i) Millbank received the face amount of the FMI promissory note in the amount of $193,913,043.
(ii) $193,529,462 of that $193,913,043 was returned by Millbank to 540 by way of reduction of 540's capital in Millbank. The difference between these two amounts, $383,581, was recorded by Millbank as a reduction of accrued interest on loan #1 for the period of June 23, 1987 to June 30, 1987. The payment to 540 took the form of a cheque issued by FMI to 540 for $193,529,462.
(iii) 540 applied this $193,529,462 to cancel most of Novopharm's shares in 540. 540 endorsed the FMI cheque in favour of Novopharm for this purpose.
(iv) Novopharm then endorsed this FMI cheque in favour of FMCC to repay the principal amount of loan #2, which was $173,922,008, and $19,607,454 on account of the accrued, but as yet unpaid, interest thereon, which was $19,617,450. The remaining interest, $9,996, was paid by Novopharm to FMCC by its own cheque.
[20] On the cancellation of its shares in 540, Novopharm realized a deemed dividend in the amount of $19,170,433 pursuant to subsection 84(3) of the Act, which it included in computing its income for income tax purposes for the 1988 taxation year, and also deducted pursuant to subsection 112(1) of the Act.
[21] Notwithstanding the .05 percent difference between the loan rates on loan #1 and loan #2 (11.5%) and the rate payable on the FMI note (11.55%), the interest paid on loan #1 ($383,581) and on loan #2 ($19,617,450) (a total of $20,001,031) exceeded the interest paid on the FMI note ($19,991,035), producing a shortfall of $9,996, the amount which Novopharm paid to FMCC. ...
[22] Novopharm deducted for income tax purposes $10,027,914 and $9,579,540 (a total of $19,607,454) of the interest of $19,617,450 paid or accrued in respect of loan #2 in computing its income for its 1987 and 1988 taxation years, respectively. ... Millbank deducted the interest of $383,581 paid on loan #1 in its 1987 and 1988 fiscal periods. Novopharm also deducted in computing its income for the 1987 taxation year the loan arrangement fee of $500,000 paid in respect of loan #2, and the $200,000 fee paid to Laventhol & Horwath.
Subparagraph 20(1)(c)(i) - The Interest Deduction
[6] Subparagraph 20(1)(c)(i) provides:
| 20. (1) Notwithstanding paragraphs 18(1)(a), 18(1)(b) and 18(1)(h), in computing a taxpayer's income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto ... (c) an amount paid in the year or payable in respect of the year (depending on the method regularly followed by the taxpayer in computing the taxpayer's income), pursuant to a legal obligation to pay interest on (i) borrowed money used for the purpose of earning income from a business or property (other than borrowed money used to acquire property the income from which would be exempt or to acquire a life insurance policy), [Emphasis added] |
20. (1) Malgré les alinéas 18(1)a), b) et h), sont déductibles dans le calcul du revenu tiré par un contribuable d'une entreprise ou d'un bien pour une année d'imposition celles des sommes suivantes qui se rapportent entièrement à cette source de revenus ou la partie des sommes suivantes qu'il est raisonnable de considérer comme s'y rapportant: ... c) la moins élevée d'une somme payée au cours de l'année ou payable pour l'année (suivant la méthode habituellement utilisée par le contribuable dans le calcul de son revenu) et d'une somme raisonnable à cet égard, en exécution d'une obligation légale de verser des intérêts sur: (i) de l'argent emprunté et utilisé en vue de tirer un revenu d'une entreprise ou d'un bien (autre que l'argent emprunté et utilisé pour acquérir un bien dont le revenu serait exonéré ou pour contracter une police d'assurance-vie), [Je souligne] |
[7] The Tax Court Judge found that the transactions in this case had no purpose other than tax avoidance. Subparagraph 20(1)(c)(i) requires that in order to deduct interest, borrowed money must be used for the purpose of earning income from a business or property. In his view, the borrowing in this case did not meet the requirement of subparagraph 20(1)(c)(i) because its purpose was solely tax avoidance and not the earning of income.
[8] The Tax Court Judge distinguished the present case from the decisions of the Supreme Court of Canada in Shell Canada Ltd. v. Canada, [1999] 3 S.C.R. 622, Ludco Enterprises Ltd. v. Canada, [2001] 2 S.C.R.1082, and Singleton v. Canada, [2001] 2 S.C.R.1046, and instead found that the present case was similar to the Tax Court decisions in Mark Resources Inc. v. The Queen, 93 D.T.C. 1004 (T.C.C.) and Canwest Broadcasting Ltd. v. The Queen, 96 D.T.C. 1375 (T.C.C.). At paragraph 55 of his reasons, the learned Judge states:
... It is true that the series of transactions carried out in each of Mark Resources, Canwest and this case are not identical. What they have in common, however, and what distinguishes them all from Shell, Ludco and Singleton, is that in each of these cases an elaborate series of transactions was carried out for no other reason than to create an interest deduction in the profitable corporation, while ensuring that the corresponding yield from borrowed funds became income of the loss company, which then passed into the hands of the profitable company as an intercorporate dividend, free of taxation.
[9] In my view, for purposes of subparagraph 20(1)(c)(i), the issue is whether to treat all the transactions here as a series of connected transactions or as independent transactions. If all the transactions are treated as a series of connected transactions, the conclusion of the Tax Court Judge will be reached. The purpose of the scheme was solely tax avoidance and not the earning of income.
[10] However, if the transactions are considered independently, the borrowing will be found to be used for the purpose of earning income, namely for the purpose of purchasing shares in a corporation from which a dividend could be expected and from which a dividend was deemed to have been received. The associated interest would be deductible under subparagraph 20(1)(c)(i).
[11] I am of the opinion that Singleton is dispositive of the issue. In Singleton, a lawyer used funds in his capital account at his law firm to purchase a home. He replaced the funds he took out of the capital account with funds borrowed from a bank. The Supreme Court found the interest to be deductible because the borrowings were used to refinance the lawyer's capital account at the firm. At paragraphs 33, 34 and 35, Major J. stated:
[33] This characterization of the use of the funds is not altered by the fact that the respondent used the money he withdrew from the firm to purchase a house. Nor is it altered by the fact that the transactions occurred on the same day.
[34] In my respectful opinion, it is an error to treat this as one simultaneous transaction. In order to give effect to the legal relationships, the transactions must be viewed independently. When viewed that way, on either version of the facts (i.e. regardless of the sequence), what the respondent did in this case was use the borrowed funds for the purpose of refinancing his partnership capital account with debt. This is the legal transaction to which the Court must give effect. In this regard, I adopt the following reasons of Rothstein J.A. (at para. 54):
In the case at bar, the direct use of the borrowed funds was to refinance the appellant's capital account at the firm. Treating the borrowed funds as used for financing the purchase of the home ignores what the appellant actually did, i.e. used the borrowed funds to replace the funds required for his capital account at the firm. As stated by Dickson C.J. in Bronfman Trust, the Court cannot ignore the direct use to which the appellant put the borrowed money.
[35] The fact that the money was borrowed in order to allow the respondent to use his own money to purchase the house is of no moment. The Shell decision decided that why the money was borrowed is irrelevant. The fact that money was transferred from the firm to the respondent for the purchase of a residential property has no impact on the application of s. 20(1)(c)(i) to the interest incurred on borrowed money which was used directly for the purpose of refinancing the capital, and as such used for the purpose of earning income from the law firm. [Emphasis added]
[12] By the same token, if all the transactions in this case are treated as a series of connected transactions, the actual facts - that Novopharm borrowed money for the purchase of shares in a company to earn dividend income - are given no meaning. That was the direct use of the borrowed funds and the direct use cannot be ignored. Subparagraph 20(1)(c)(i) does not contemplate treating individual transactions as a series of transactions. Viewing the transactions independently, Novopharm's borrowing was used for the purpose of earning income and meets the requirements of subparagraph 20(1)(c)(i).
[13] The Minister says that what Novopharm received was, in reality, a return of capital and not dividend income. He says that the amount was only deemed to be a dividend by virtue of subsection 84(3) and that deeming provision should be ignored in favour of reality. The fact that the dividend received by Novopharm was a deemed dividend pursuant to subsection 84(3) is of no consequence. A deeming provision is a statutory fiction that replaces or modifies reality; it cannot be ignored. See OSFC Holdings Ltd. v. Canada, [2002] 2 F.C. 288 (C.A.) at paragraph 33. A deeming provision may favour the Minister in one case, or the taxpayer in another. It is not to be disregarded simply because it favours the taxpayer.
Subparagraph 20(1)(e)(ii) - The Loan Arrangement Fee
[14] Subparagraph 20(1)(e)(ii) provides:
| 20. (1) Notwithstanding paragraphs 18(1)(a), 18(1)(b) and 18(1)(h), in computing a taxpayer's income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto ... (e) such part of an amount (other than an excluded amount) that is not otherwise deductible in computing the income of the taxpayer and that is an expense incurred in the year or a preceding taxation year ... (ii) in the course of a borrowing of 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), [Emphasis added] |
20. (1) Malgré les alinéas 18(1)a), b) et h), sont déductibles dans le calcul du revenu tiré par un contribuable d'une entreprise ou d'un bien pour une année d'imposition celles des sommes suivantes qui se rapportent entièrement à cette source de revenus ou la partie des sommes suivantes qu'il est raisonnable de considérer comme s'y rapportant: ... e) la partie d'un montant (sauf un montant exclu) qui n'est pas déductible par ailleurs dans le calcul du revenu du contribuable et qui est une dépense engagée au cours de l'année ou d'une année d'imposition antérieure: ... (ii) soit dans le cadre d'un emprunt d'argent que le contribuable utilise en vue de tirer un revenu d'une entreprise ou d'un bien, sauf s'il s'agit d'argent utilisé par le contribuable en vue d'acquérir un bien dont le revenu serait exonéré, [Je souligne] |
[15] The reasoning applicable to the interest deduction is applicable here. Because I have found that Novopharm's borrowing was used for the purpose of earning income from a business or property, it follows that the loan arrangement fee incurred in the course of borrowing meets the requirements of subparagraph 20(1)(e)(ii).
Subsection 9(1) and Paragraph 18(1)(a) - The Consulting Fee
[16] Subsection 9(1) and paragraph 18(1)(a) provide:
| 9. (1) Subject to this Part, a taxpayer's income for a taxation year from a business or property is the taxpayer's profit from that business or property for the year. |
9. (1) Sous réserve des autres dispositions de la présente partie, le revenu qu'un contribuable tire d'une entreprise ou d'un bien pour une année d'imposition est le bénéfice qu'il en tire pour cette année. |
| 18. (1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of (a) an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property; [Emphasis added] |
18. (1) Dans le calcul du revenu du contribuable tiré d'une entreprise ou d'un bien, les éléments suivants ne sont pas déductibles: a) les dépenses, sauf dans la mesure où elles ont été engagées ou effectuées par le contribuable en vue de tirer un revenu de l'entreprise ou du bien; [Je souligne] |
The issue here turns on whether the consulting fee meets the purpose test in paragraph 18(1)(a).
[17] The Minister did not attempt to distinguish the purpose test in paragraph 18(1)(a) and subparagraph 20(1)(c)(i) on the basis of any difference in wording between the two. The words "... for the purpose of gaining or producing income from the business or property ...", I think, have the same meaning as "... for the purpose of earning income from a business or property ..." for the purposes of this case. Therefore, the same analysis is applicable to paragraph 18(1)(a) as to subparagraph 20(1)(c)(i).
[18] The Minister did make reference toDeputy Minister of National Revenue (Quebec) v. Lipson, [1979] 1 S.C.R. 833, where, at page 839, in relation to sections 5 and 15 of the Provincial Income Tax Act (R.S.Q. 1964, c. 69) (virtually identical to subsection 9(1) and paragraph 18(1)(a) of the Income Tax Act), Pigeon J. stated:
It is perfectly clear from these provisions that, in order for an expense to be admissible as a deduction from a taxpayer's income, it must have been incurred in order to make a profit. It is not enough that the expense was incurred in order to obtain gross income, as counsel argued at the hearing. [Emphasis in original]
The Minister here says that Novopharm's purpose was not to make a profit as its transactions could only result in a loss of $3.5 million and, for that reason, the consulting fees should be disallowed.
[19] However, more recent decisions of the Supreme Court of Canada indicate that, at least with respect to subparagraph 20(1)(c)(i), income is not equivalent to profit or net income. At paragraph 59 of Ludco, Iacobucci J. states:
Because it is left undefined in the Act, this Court must apply the principles of statutory interpretation to discern what is meant by "income" in the context of s. 20(1)(c)(i). The plain meaning of s. 20(1)(c)(i) does not support the interpretation of "income" as the equivalent of "profit" or "net income". Nowhere in the language of the provision is a quantitative test suggested. Nor is there any support in the text of the Act for an interpretation of "income" that involves a judicial assessment of sufficiency of income. Such an approach would be too subjective and certainty is to be preferred in the area of tax law. Therefore, absent a sham or window dressing or similar vitiating circumstances, courts should not be concerned with the sufficiency of the income expected or received.
Although his determination is with respect to the definition of income in subparagraph 20(1)(c)(i), the relevant words are so close to those in paragraph 18(1)(a) that it would be difficult to justify a different interpretation with respect to paragraph 18(1)(a).
[20] The Minister submits that paragraph 18(1)(a) is generally aimed at deductions of outlays which are not profit motivated. However, I think the rationale outlined by Iacobucci J. in Ludco, as to why income in subparagraph 20(1)(c)(i) is not equivalent to profit or net income, is equally applicable to paragraph 18(1)(a). Nowhere in the language of paragraph 18(1)(a) is a quantitative test suggested. Nor is there any support in the words of paragraph 18(1)(a) that suggests a judicial assessment of the sufficiency of income. And, as with subparagraph 20(1)(c)(i), such an assessment would be too subjective where certainty is to be preferred. For these reasons, I am of the opinion that the view of Pigeon J. in Lipson, supra, to the extent that it may have been applied to paragraph 18(1)(a), must now be considered to have been superseded by the rationale in Ludco.
[21] Therefore, consistent with my conclusion with respect to interest deductible under subparagraph 20(1)(c)(i) and the loan arrangement fee deductible under subparagraph 20(1)(e)(ii), the consulting fee incurred for the purpose of gaining or producing income meets the requirements for deductibility and deductibility is not precluded under paragraph 18(1)(a).
Subsection 245(1)
[22] Subsection 245(1) provides:
| 245. (1) In computing income for the purposes of this Act, no deduction may be made in respect of a disbursement or expense made or incurred in respect of a transaction or operation that, if allowed, would unduly or artificially reduce the income. |
245.(1) Dans le calcul du revenu aux fins de la présente loi, aucune déduction ne peut être faite à l'égard d'un débours fait ou d'une dépense faite ou engagée, relativement à une affaire ou opération qui, si elle était permise, réduirait indûment ou de façon factice le revenue. |
[23] As earlier indicated, subsection 245(1) was repealed and was replaced by a new section 245 which is referred to as the General Anti-avoidance Rule. However, subsection 245(1) was in place at the time of the transactions in this case.
The approach to subsection 245(1) adopted by the Tax Court Judge
[24] The learned Tax Court Judge had regard to the factors established by this Court in Canada v. Fording Coal Ltd. (C.A.), [1996] 1 F.C. 518 and adopted in Canada v. Central Supply Company (1972) Ltd. (C.A.), [1997] 3 F.C. 674, in assessing whether Novopharm's deductions unduly or artificially reduced income for purposes of subsection 245(1). The factors are:
1. would the deduction, if permitted, be contrary to the object and spirit of the Income Tax Act;
2. are the transactions giving rise to the deductions made in accordance with normal business practice; and
3. were the transactions entered into for bona fide business purposes?
Applying the Fording approach, the Tax Court Judge concluded that Novopharm's appeal failed under subsection 245(1).
Should the Fording approach be followed?
[25] The analysis under subsection 245(1) must commence with the identification of the proper approach to determine whether deductions would unduly or artificially reduce income. The question is not without some controversy. As noted by McLachlin J. (as she then was) in Shell at paragraph 55, this Court has not always taken the Fording approach with respect to subsection 245(1). That was particularly the case, she observed, with respect to the bona fide business purpose factor. She found its use in Fording and Central Supply to appear "to run against the grain of some of the Federal Court of Appeal's earlier interpretations of this provision and its predecessors". McLachlin J. did not find it necessary to "determine conclusively the proper interpretation to be given to s. 245(1)" (paragraph 56). In not conclusively interpreting subsection 245(1), she noted that the provision "has now been repealed and replaced by a new anti-avoidance tool" (paragraph 60).
[26] The other approach to interpreting subsection 245(1) by this Court says that, where a deduction comes about by specific operation of the Act, the deduction cannot be said to be undue or artificial. See, for example, Canada v. Mara Properties Ltd., [1995] 2 F.C. 433 (C.A.) per: Marceau J.A. at pages 437-438, and per: McDonald J.A. at page 452.
[27] The question then is whether, in this appeal, this Court should follow the majority in Fording on the one hand or the approach found in Mara Properties, on the other, or indeed, whether this Court should adopt yet another approach for application of subsection 245(1).
[28] I am impelled to the conclusion that the Fording approach should be followed. This is not because I think I am bound to follow it under the doctrine of stare decisis. It is true that a court of intermediate appellate jurisdiction, save in exceptional circumstances, should follow its own prior decisions. However, one of those exceptional circumstances is where the court's prior decisions are in conflict, in which case, the court is entitled and bound to decide which of two conflicting decisions it will follow. See Young v. Bristol Aeroplane Co. Ltd., [1944] 2 All E.R. 293 at 398; Canada (Minister of Employment and Immigration) v. Widmont, [1984] 2 F.C. 274 (C.A.);and Armstrong Cork Canada Ltd. v. Domco Industries Ltd., [1981] 2 F.C. 510 (C.A.).
[29] I do not think the Mara Properties approach should be followed. In Harris v. Canada (Minister of National Revenue), [1966] S.C.R. 489, Cartwright J. (as he then was), in obiter, observed that even if a deduction were permitted by an express provision of the Income Tax Act, if the deduction artificially reduced income, the deduction could be disallowed pursuant to subsection 137(1) (subsequently subsection 245(1)). At page 505 he stated:
If, contrary to the views I have expressed, we had accepted the appellant's submission that the transaction embodied in the lease was one to which s. 18 applied and that on the true construction of the lease and the terms of that section the appellant was prima facie entitled to make the deduction of the capital cost allowance of $30,425.80 claimed by him, I would have had no hesitation in holding that it was a deduction in respect of an expense incurred in respect of a transaction that if allowed would artificially reduce the income of the appellant and that consequently its allowance was forbidden by the terms of s. 137(1).
I am aware that the judgment in Harris has been subject to some criticism, but not with respect to the point at issue here. See, for example, Gordon McKee v. The Queen 77 D.T.C. 5345. It is also true that Cartwright J.'s observation was obiter dicta. However, obiter comments of the Supreme Court are not to be lightly disregarded. (See Cardella v. Canada, 2001 FCA 39; [2001] F.C.J. No. 322 at para. 37.)
[30] It seems to me that the interpretation of subsection 245(1) proposed by Cartwright J. must be correct. Otherwise subsection 245(1) would have no application if there was a specific section that allowed the deduction. In this Court's decision in The Queen v. Alberta and Southern Gas Co. Ltd., [1978] 1 F.C. 454, Jackett C.J. explained at page 459-460:
With great respect, I cannot agree that the rule of interpretation referred to by the learned Trial Judge [that a special section rather than a general section must govern] excludes the application of section 245(1) to an amount that would otherwise be deductible under section 66. If it does, it is difficult to think of any case where section 245(1) would apply inasmuch as, in relation to any provision providing for a deduction in computing income, section 245(1) is always, by its nature, a general provision. Parliament must have intended the provision to have some effect and a non-statutory rule of interpretation is merely a crystallization of the judicial reasoning employed in ascertaining Parliament's intention in enacting a particular provision.
Strayer J.A. adopted this reasoning in Fording at paragraph 13.
[31] For these reasons, I do not think the Mara Properties approach should be followed.
[32] Whatever one might say about the breadth of the Fording approach, it was applied in Central Supply and since Central Supply, this Court has not had occasion to deviate from that approach. Indeed, in this Court's decision in Canada v. Shell Canada Ltd. (C.A.), [1998] 3 F.C. 64, at paragraphs 2 to 6, Stone J.A., the only judge to deal with subsection 245(1), applied the Fording approach. Since Fording, no court has followed the Mara Properties approach with respect to interpreting subsection 245(1), (see Chambers v. Canada, 96 D.T.C. 6095 (F.T.D.); Gibson Petroleum Co. v. Canada, 97 D.T.C. 1420 (T.C.C.)).
[33] Especially in tax jurisprudence, where consistency and predictability of the law are particularly important to taxpayers and the Government alike, I think the Court must establish one approach and follow it. If a party is dissatisfied, its remedy is appeal. I recognize that, subsection 245(1) having been repealed some fifteen years ago, there may be little incentive for the Supreme Court to grant leave. Nonetheless, especially in its tax jurisprudence, this Court should follow a consistent approach to interpretation, in this case, reflected in the decisions of this Court following Fording.
[34] For these reasons, I think the Fording approach should be followed.
Was the entire series of transactions relevant for purposes of subsection 245(1)?
[35] Under the Fording approach, the series of related transactions are considered and not just the transaction which gave rise to the claimed deduction. As I earlier indicated, Singleton established that, in interpreting subparagraph 20(1)(c)(i), the correct focus is on the direct use to which borrowed funds are put and that all related transactions in a series are not envisaged by that provision. That is not the case under subsection 245(1).
[36] Having regard to the series of related transactions is consistent with the focus of subsection 245(1), which, for purposes of this case, is whether the deductions artificially reduce income. This is in contrast to subparagraph 20(1)(c)(i) which requires that interest be payable on borrowed money used for the purpose of earning income from a business or property. If artificiality is to be given some meaning, it cannot be constrained to a consideration only of whether the direct use of the borrowed funds was to earn income, i.e. only the transaction in which the borrowed funds were used to buy shares in Royal Scot from which a deemed dividend was received. If only the direct use of borrowed funds were to be considered, compliance with subparagraph 20(1)(c)(i) would, in all cases, be dispositive of the question of artificiality. Having regard to the obiter comments of Cartwright J. in Harris and the explanation of Jackett C.J. in Alberta and Southern Gas, that cannot be the way in which subsection 245(1) is to be interpreted.
[37] Further, it is true that subsection 245(1) uses the words "... deduction ... made in respect of a ... expense ... incurred in respect of a transaction ...". However, again having regard to Harris and Alberta and Southern Gas, these words cannot limit the subsection 245(1) inquiry to the single transaction giving rise to the deduction. If they did, I again do not see how a finding that a deduction unduly or artificially reduced income could ever be made. The premise of subsection 245(1) is that a transaction takes place that results in an expense being incurred which the taxpayer seeks to deduct from income. Narrowing the focus in this case solely to the deduction in respect of the interest expense incurred would not address the question of whether the deduction would unduly or artificially reduce income. Rather, it is necessary to have regard to other facts to determine the question.
[38] Thus, for example, if the Minister alleged an interest deduction unduly reduced income because the interest rate was excessive, it would be necessary to have regard to market rates of interest at the relevant time and the reasons why the interest rate paid was as high as it was. If only the interest payment transaction was considered and market rates and other considerations were ignored, a finding of undueness could never be made. By the same token, when it is contended by the Minister that a deduction artificially reduces income, it is necessary to have regard to all the relevant circumstances and, in particular, to the series of transactions related to the transaction in respect of which the interest expense is incurred.
[39] Under subsection 245(1), the question is whether the deduction made in respect of an expense would artificially reduce income, or, more colloquially, would unnaturally reduce income. This is a broader inquiry than one dealing with whether the direct use of borrowed funds was for the purpose of earning income or whether a particular transaction gave rise to an expense which was sought to be deducted. In accordance with the Fording approach, all the circumstances must be considered to properly answer the question of artificiality. The Tax Court Judge considered the series of related transactions in this case to determine whether the interest deduction artificially reduced income. He was correct in doing so.
Application of the Fording Approach
[40] Applying the Fording approach, the learned Tax Court Judge first found that the "spirit" of subparagraph 20(1)(c)(i) was to permit the deduction of interest in order to encourage the accumulation of capital which would then produce taxable income. This purpose of subparagraph 20(1)(c)(i) was identified by Dickson J. in Bronfman Trust v. The Queen, [1987] 1 S.C.R. 32 at 45, and was referred to by McLachlin J. in Shell (paragraph 57) and by Iacobucci J. in Ludco. In Ludco, Iacobucci J. stated at paragraph 63:
Furthermore, reading "income" in s. 20(1)(c)(i) to mean income generally, as described above, is more consistent with the objective of the interest deductibility provision. In most circumstances, ss. 9 and 18(1)(b) of the Act prohibit the deduction of amounts expended on account of capital. Section 20(1)(c)(i) is an exception to this prohibition, designed to encourage the accumulation of capital which would produce income: see Shell Canada, supra, at para. 28, per McLachlin J.; Tennant v. M.N.R., [1996] 1 S.C.R. 305, at para. 16, per Iacobucci J.; Bronfman Trust, supra, at p. 45, per Dickson C.J. Thus, the object of s. 20(1)(c)(i) is to create an incentive to accumulate capital with the potential to produce income by allowing taxpayers to deduct interest costs associated with its acquisition. The accumulation of income-producing capital is seen as desirable because it creates wealth and increases the income tax base. It is clearly sufficient for the purpose of the provision that an investor have a reasonable expectation of gross income as described above when investing borrowed money. In contrast, the incentive would be much less effective if the investor bore the additional burden of establishing a reasonable expectation of net income or profit. [Emphasis added]
The object and spirit of a provision must be clear and unambiguous to be invoked for purposes of subsection 245(1). See OSFC at paragraphs 39 and 40, in relation to the misuse and abuse analysis under the new section 245. In the case of subparagraph 20(1)(c)(i), there is no doubt as to its object and spirit because its object has been the subject of consistent observation and explanation by the Supreme Court.
[41] For the reasons I have given, in dealing with an assessment under subsection 245(1), the Tax Court Judge was entitled to have regard to the series of related transactions which gave rise to Novopharm's interest deductions in 1987 and 1988 and determine if they would artificially reduce Novopharm's income. The result of the series of related transactions that took place over a short period of time in this case was solely to create a net interest deduction for Novopharm that reduced its income, the antithesis of the object of subparagraph 20(1)(c)(i), to create an incentive to accumulate capital with the potential to produce income. In deducting its own net interest expense in this case, Novopharm was solely engaging in tax avoidance, and as found by the Tax Court Judge, not acting in accordance with the object and spirit of subparagraph 20(1)(c)(i).
[42] The Tax Court Judge then considered the normal business practice factor and found that the transactions here were not ones that would be entered into in the normal course of business. He found that "... these preordained transactions ("a package deal") could only result in the loss by Novopharm of some $3.5 million", i.e. the cost of acquiring Royal Scot and fees and expenses with respect to the series of transactions.
[43] It is not entirely clear to me that pre-ordained transactions that can only result in a loss can never be in accordance with normal business practice. It seems to me that in carrying on business or investing in property, transactions may be structured with a view to tax minimization or tax avoidance and, viewed in isolation, the cost of structuring those transactions may be considered a net expenditure resulting in a loss. Yet, that does not mean that they are not in accordance with normal business practice. Taxpayers are entitled to structure their affairs in a manner that reduces the tax payable. See Shell at paragraph 46. When they do so in accordance with normal business practice, the fact that there is a cost associated with the transactions will not render deductions resulting from the transactions as artificially reducing income.
[44] Here, however, a series of related transactions were entered into that were pre-ordained, circular and limited in time. At the end of the relatively brief period during which the transactions were completed, nothing had changed except for Novopharm's claimed tax deductions. There were no ongoing consequences of the transactions once they were completed. It is true that the Millbank Limited Partnership continued to operate. However, as found by the Tax Court Judge, its continuing operations had nothing to do with Novopharm's loan which gave rise to its claimed interest deduction in this case. It is the combination of the pre-ordination of the transactions, their circularity and the limited amount of time during which they were all completed that took them out of normal business practice and rendered the deduction for interest expense by Novopharm artificial.
[45] As to the bona fide business purpose factor, the Tax Court Judge observed that Novopharm did not contend there was such a purpose and that no explanation of a bona fide business purpose was given. There was no different position taken by Novopharm in this Court.
Other subsection 245(1) arguments of Novopharm
Were the Minister's pleadings adequate?
[46] Novopharm advances a number of arguments as to why the Tax Court Judge was in error in his subsection 245(1) conclusion. First, Novopharm says the Minister failed to plead assumptions of fact that supported his invocation of subsection 245(1). This argument appears to be that the Minister had the burden to establish facts supporting his subsection 245(1) assessment and that he failed to do so.
[47] A review of the Minister's reply to Novopharm's notice of appeal in the Tax Court reveals that the Minister expressly invoked subsection 245(1) as a basis for reassessment. The reply sets out, in great detail, Novopharm's transactions and the Minister's view of the objective of the transactions. There is no suggestion that Novopharm did not have fair notice of the Minister's position with respect to the effect of these transactions or that the Minister intended to rely upon the Fording approach.
[48] As the Tax Court Judge assessed the evidence, it did not satisfy the object and spirit and the normal business practice factors, and Novopharm did not allege the transaction had a bona fide business purpose. The assessment of evidence was for the Tax Court Judge. He was satisfied the evidence supported the Minister's subsection 245(1) assessment, according to the Fording approach. This Court will not interfere with the assessment of evidence by a Trial Judge, barring palpable and overriding error, which is not alleged or present here.
Is subparagraph 20(1)(c)(i) a complete anti-avoidance code?
[49] Novopharm argues that subparagraph 20(1)(c)(i) is a complete code of anti-avoidance principles leaving no room for application of subsection 245(1). Novopharm cited no authority in support of this proposition. McLachlin J. had no difficulty applying subsection 245(1) in Shell and did not indicate that compliance with subparagraph 20(1)(c)(i) was a complete answer to an assessment under subsection 245(1), as she did with respect to section 67 of the Act.
Is motivation irrelevant and are the Fording factors objective?
[50] Novopharm says that its tax avoidance motivation or intention is not relevant in an assessment under subsection 245(1) and that this Court should have regard to objective, rather than subjective, factors in determining whether a subsection 245(1) assessment should be upheld. Novopharm does not state precisely what objective factors should be applied. Be that as it may, it appears that this is another argument for restricting the subsection 245(1) analysis to the direct use to which the borrowed funds are put. For the reasons already given, I do not accept this argument. Subsection 245(1) mandates a broader consideration. In any event, Novopharm has not demonstrated why the Fording approach itself is not objective.
Was reduction of income undue?
[51] Novopharm says that the undue reduction of income in subsection 245(1) cannot be applicable because the interest rate charged in this case was not in excess of the market rate. Whether Novopharm is correct on this point is of no consequence, because Novopharm's transactions did result in the artificial reduction of income according to the Fording approach. I recognize that the Fording approach may apply to both the questions of whether a reduction of income is undue or artificial (see Shell at paragraph 56). However, in this case, the approach certainly applies to demonstrate that the deduction of interest resulted in the artificial reduction of Novopharm's income.
Was the Fording approach superseded by subsequent Supreme Court jurisprudence?
[52] Finally, Novopharm says that the Fording approach is inconsistent with more recent pronouncements of the Supreme Court of Canada pertaining to interest deductibility. In its factum, Novopharm did not cite any subsequent Supreme Court jurisprudence upon which it relied. In oral argument, Novopharm referred to Singleton and Ludco. In Ludco, the Court explicitly found there to be no basis for incorporating into a subparagraph 20(1)(c)(i) analysis a bona fide business purpose test. But, neither Singleton nor Ludco was based on subsection 245(1) assessments and are not applicable to interpreting subsection 245(1).
[53] In Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536, Estey J., in obiter, noted at page 574:
The courts may, of course, develop, in their interpretation of s. 137 [now subsection 245(1)] doctrines such as the bona fide business purpose test; or a step-by-step transaction rule for the classification of taxpayers' activities which fall within the ban of such a general tax avoidance provision.
Subsection 245(1) was interpreted in Fording as including consideration of the bona fide business purpose test. Novopharm did not refer the Court to any Supreme Court jurisprudence subsequent to Stubart that rejected the bona fide business purpose test as relevant under subsection 245(1).
[54] For these reasons, I have not been persuaded by these other arguments of Novopharm.
CONCLUSION
[55] Because the interest deduction taken by Novopharm artificially reduced its income, I am of the opinion that the learned Tax Court Judge was correct in finding that Novopharm's appeal before him failed on the basis of subsection 245(1).
[56] Because the loan arrangement fee was incurred in the course of borrowing money that resulted in an interest expense which artificially reduced Novopharm's income, I am of the opinion that the loan arrangement fee was also a deduction that artificially reduced income. Similarly, the consulting fee, having been incurred to obtain the interest deduction that artificially reduced Novopharm's income, the consulting fee must also be considered a deduction that artificially reduced income.
[57] The appeal should be dismissed with costs.
"Marshall Rothstein"
J.A.
"I agree
A.J. Stone J.A."
"I agree
B. Malone J.A."
FEDERAL COURT OF APPEAL
NAMES OF COUNSEL AND SOLICITORS OF RECORD
DOCKET: A-24-02
STYLE OF CAUSE: NOVOPHARM LIMITED v. HER MAJESTY THE
QUEEN
PLACE OF HEARING: Toronto
DATE OF HEARING: January 15, 2003
REASONS FOR JUDGMENT: ROTHSTEIN J.A.
CONCURRED IN BY: STONE, MALONE JJ.A.
DATED: March 5, 2003
APPEARANCES:
Terrance A. Sweeney
Ian V. MacInnis
FOR THE APPELLANT
Luther Chambers, Q.C.
George Boyd Aitken
FOR THE RESPONDENT
SOLICITORS OF RECORD:
FOGLER, RUBINOFF LLP
Toronto, Ontario FOR THE APPELLANT
BORDEN LADNER GERVAIS LLP
Toronto, Ontario FOR THE APPELLANT
Mr. Morris Rosenberg
Deputy Attorney General of Canada
Ottawa, Ontario FOR THE RESPONDENT