Date: 20000409
Docket: 98-2561-IT-G
BETWEEN:
CANADIAN HELICOPTERS LIMITED,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasons for Judgment
McArthur, J.
[1] The Appellant, Canadian Helicopters Limited (CHL), appeals reassessments of tax for its 1990 and 1991 taxation years. The first issue is whether the interest of $578,970 and $1,021,820, respectively, paid by the Appellant constitutes interest on borrowed money used for the purpose of earning income from a business or property pursuant to paragraph 20(1)(c) of the Income Tax Act (the Act). The problem, in a nut shell, is that the Appellant borrowed the money to purchase Viking Helicopters Ltd. (Viking), paid the interest, yet its parent corporation took title to the shares. The second issue is whether certain expenses incurred in Thailand were an outlay or expense of the Appellant made or incurred by the taxpayer for the purpose of gaining or producing income from a business or property pursuant to paragraph 18(1)(a) of the Act.
[2] For the most part, the relevant facts are not in dispute. The Appellant is a Canadian corporation with its head office in St. John's, Newfoundland. It is in the business of transportation by helicopters, and the leasing and servicing of helicopters throughout the world.
[3] During the relevant years, its parent company was CHC Helicopter Holdings Ltd. (Holdings) and Holdings' parent company was CHC Helicopter Corporation Ltd. (CHC). From 1985, it had been aggressively acquiring similar helicopter businesses. In May 1989, CHC entered into an agreement to purchase the shares of Viking Helicopters Ltd. (Viking) of Québec. The Appellant borrowed US$30 million (US loan) in August from US West Financial Services Inc. (USWFS). It loaned US$20 million to Viking with an interest rate equal to that charged by USWFS. It loaned US$8.95 million to Holdings who in turn loaned the same amount to CHC. CHC paid this amount to Viking for its shares. The Appellant did not record any specific arrangements on its loan to Holdings and in fact Holdings did not pay it any interest and the Minister disallowed its claim to deduct the interest paid on the US$8.95 million.
[4] The documents entered in evidence indicate that:
a) On May 10, 1989, CHC entered into an agreement with Corporation Provost Ltée to purchase the shares of Viking. The agreement provided that CHC could assign the agreement to a subsidiary or parent of CHC.
b) On July 21, 1989, USWFS issued a commitment letter to CHC approving financing to CHL for the purpose of permitting CHL to purchase the shares of Viking and for other general business purposes.
c) The closing date of the purchase agreement was agreed to be August 31, 1989.
d) On August 25, 1989, the directors of CHL resolved to borrow US30 million from USWFS in order to "finance the acquisition by the Corporation (CHL) of Viking" and for other business purposes.
e) On August 31, 1989, the loan agreement between USWFS and CHL provided that the purpose of CHL's loan was "as to not more than C$10,000,000, to finance on the initial drawdown date an inter-company loan to Holdings to finance a further loan to CHC to finance its acquisition of all issued and outstanding shares of Viking".
f) On September 13, 1989, a CHC corporate group internal memorandum was issued requesting that the financial statements reflect the following transactions:
i) CHL loaned to Holdings $8.95 million secured by a promissory note;
ii) Holdings loaned to CHC $8.95 million also secured by a promissory note,
iii) CHC used the $8.95 million to purchase the shares of Viking.
[5] The Minister disallowed the Appellant's claim for expenses from a contract to supply helicopters used in the oil industry in Thailand. The problem with respect to the Thailand expense is that it was Thai Aviation Services Limited (TASL) that carried on business in Thailand and not the Appellant.
Legislation
[6] Both parties rely on paragraph 18(1)(a) of the Act with respect to the Thailand expenses and paragraph 20(1)(c) of the Act with respect to the deduction of interest. These paragraphs read as follows:
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;
...
20(1) Notwithstanding paragraphs 18(1)(a), (b) and (h), in computing a taxpayer's income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto:
...
(c) an amount paid in the year or payable in respect of the year (depending 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),
...
or a reasonable amount in respect thereof, whichever is the lesser;
...
Position of the Appellant
[7] The Appellant borrowed the US$8.95 million for the direct and eligible purpose of earning income from business or property. Counsel added that the consideration the Appellant received for re-loaning the funds interest-free to its parent company included the following:
i) Taking over the Viking non-Quebec operations, in Ontario, Manitoba, Newfoundland and Gabon, Africa, worth $7,000,000 to $9,000,000 in gross annual revenues;
ii) The right for it to charge important management fees to Viking which, from a practical viewpoint, was to become a division of CHL;
iii) Not being charged either by Holdings or by CHC a guarantee fee on a $40,000,000 loan which in the normal course, would have been in the amount of between $400,000 and $800,000;
iv) Not being charged by CHC for the benefit of a five-year non-competition clause signed by Provost Corporation (Viking's parent company); and
v) Eiminating CHL's main competition in Canada and Gabon.
[8] The Appellant referred to Shell Canada Limited v. The Queen et al., 99 DTC 5669 (S.C.C.) at page 5675 to support its argument that borrowed funds may be traced where there was a "sufficiently direct link between the borrowed money and the current eligible use". Counsel concluded that the consideration the Appellant received from Viking in context of the re-loan to Holdings and CHC was directly linked to its income-earning activities and its purpose in using the funds.
[9] In the alternative, counsel argued that if it was found that there was an eligible use that was indirect, then the use fell within the exceptional circumstances referred to by Dickson C.J.C. in The Queen v. Bronfman Trust, 87 DTC 5059 (S.C.C.) and analyzed in 74712 Alberta Limited v. The Queen, 97 DTC 5126 (F.C.A.) by Robertson J.A.
Position of the Respondent
[10] The Appellant's direct use was to lend the money to Holdings interest free. The Appellant borrowed the money to permit CHC to purchase the shares of Viking. The money was not borrowed for the purpose of earning income from business or property because its use was not for a direct eligible purpose.
[11] The Respondent acknowledged that the Appellant benefited as a result of CHC's purchase of the Viking shares, however, this was an indirect benefit and too remote and speculative when the loan was made to meet the requirements of paragraph 20(1)(c). Counsel for the Respondent also referred to 74712 Alberta Limited v. The Queen.
[12] With respect to the exceptional circumstances argument, the Respondent's position is that there was nothing exceptional about this transaction. The Appellant is a member of a sophisticated group of corporations and they knew what they were doing and consequently this is not what Dickson C.J.C. meant when he was referring to exceptional circumstances in Bronfman Trust.
Analysis
[13] As in many interest deduction cases that preceded it, this case involves the interpretation of Dickson C.J.C. obiter dicta in Bronfman Trust with respect to tracing borrowed funds to an eligible purpose and use. At page 5064 he stated:
... Parliament created s. 20(1)(c)(i), and made it operate notwithstanding s. 18(1)(b), in order to encourage the accumulation of capital which would produce taxable income. Not all borrowing expenses are deductible. Interest on borrowed money used to produce tax-exempt income is not deductible. Interest on borrowed money used to buy life insurance policies is not deductible. Interest on borrowings used for non-income earning purposes, such as personal consumption or the making of capital gains is similarly not deductible. The statutory deduction thus requires a characterization of the use of borrowed money as between the eligible use of earning non-exempt income from a business or property and a variety of possible ineligible uses. The onus is on the taxpayer to trace the borrowed funds to an identifiable use which triggers the deduction. Therefore, if the taxpayer commingles funds used for a variety of purposes only some of which are eligible he or she may be unable to claim the deduction: see, for example, Mills v. M.N.R., 85 DTC 632 (T.C.C.), No. 616 v. M.N.R., 59 DTC 247 (T.A.B.)
The interest deduction provision requires not only a characterization of the use of borrowed funds, but also a characterization of "purpose". Eligibility for the deduction is contingent on the use of borrowed money for the purpose of earning income. It is well established in the jurisprudence, however, that it is not the purpose of the borrowing itself which is relevant. What is relevant, rather, is the taxpayer's purpose in using the borrowed money in a particular manner: Auld v. M.N.R., 62 DTC 27 (T.A.B.) Consequently, the focus of the inquiry must be centered on the use to which the taxpayer put the borrowed funds.
[14] In a recent Supreme Court of Canada statement on the deductibility of interest under paragraph 20(1)(c), McLaughlin C.J.C. stated in Shell at pages 5674-5675:
... The deduction is therefore not available where the link between the borrowed money and an eligible use is only indirect. Interest is deductible only if there is a sufficiently direct link between the borrowed money and the current eligible use: Tennant v. M.N.R. [96 DTC 6121], [1996] 1 S.C.R. 305, at paras. 18-20, per Iacobucci, J. Furthermore, it does not necessarily matter if the borrowed funds are commingled with funds used for another purpose, provided that the borrowed funds can in fact be traced to a current eligible use.
McLaughlin C.J.C. went on to review the scope of paragraph 20(1)(c) at page 5676:
This Court has repeatedly held that courts must be sensitive to the economic realities of a particular transaction, rather than being bound to what first appears to be its legal form: Bronfman Trust, supra, at pp. 52-53, per Dickson, C.J.; Tennant, supra, at para. 26, per Iacobucci, J. But there are at least two caveats to this rule. First, this Court has never held that the economic realities of a situation can be used to recharacterize a taxpayer's bona fide legal relationships. To the contrary, we have held that, absent a specific provision of the Act to the contrary or a finding that they are a sham, the taxpayer's legal relationships must be respected in tax cases. Recharacterization is only permissible if the label attached by the taxpayer to the particular transaction does not properly reflect its actual legal effect: Continental Bank Leasing Corp. v. Canada [98 DTC 6505], [1998] 2 S.C.R. 298, at para. 21, per Bastarache, J.
Second, it is well established in this Court's tax jurisprudence that a searching inquiry for either the "economic realities" of a particular transaction or the general object and spirit of the provision at issue can never supplant a court's duty to apply an unambiguous provision of the Act to a taxpayer's transaction. Where the provision at issue is clear and unambiguous, its terms must simply be applied: Continental Bank, supra, at para. 51, per Bastarache, J.; Tennant, supra, at para. 16, per Iacobucci, J.; Canada v. Antosko [94 DTC 6314], [1994] 2 S.C.R. 312, at pp. 326-27 and 330, per Iacobbucci, J.; Friesen v. Canada [95 DTC 5551], [1995] 3 S.C.R. 103, at para. 11, per Major, J; Alberta (Treasury Branches) v. M.N.R., [1996] 1 S.C.R. 963, at para. 15, per Cory,J.
She also described the Court's role at page 5677 as follows:
... The courts' role is to interpret and apply the Act as it was adopted by Parliament. Obiter statements in earlier cases that might be said to support a broader and less certain interpretive principle have therefore been overtaken by our developing tax jurisprudence. Unless the Act provides otherwise, a taxpayer is entitled to be taxed based on what it actually did, not based on what it could have done, and certainly not based on what a less sophisticated taxpayer might have done.
Inquiring into the "economic realities" of a particular situation, instead of simply applying clear and unambiguous provisions of the Act to the taxpayer's legal transactions, has an unfortunate practical effect. This approach wrongly invites a rule that where there are two ways to structure a transaction with the same economic effect, the court must have regard only to the one without tax advantages. With respect, this approach fails to give appropriate weight to the jurisprudence of this Court providing that, in the absence of a specific statutory bar to the contrary, taxpayers are entitled to structure their affairs in a manner that reduces the tax payable: Stubart, supra, at p. 540, per Wilson, J., and at p. 557, per Estey, J.; Hickman Motors Ltd. v. Canada [97 DTC 5363], [1997] 2 S.C.R. 336, at para. 8, per McLachlin, J.; Duha, supra, at para. 88, per Iacobucci, J.; Neuman, supra, at para. 63, per Iacobucci, J. An unrestricted application of an "economic effects" approach does indirectly what this Court has consistently held Parliament did not intend the Act to do directly.
[15] Based on the facts, I have no difficulty in concluding that the Appellant borrowed US$8.95 million to permit CHC, one of its parent corporations, to purchase the Viking shares. Its direct use of the money was a loan to Holdings who in turn loaned it to CHC. The question as to why the money went first to Holdings remains unexplained. A witness for the Appellant stated that taking title in the name of CHC was a mistake. Apparently it came about because, in error, the approval of the National Transportation Agency was applied for and granted to CHC rather than the Appellant and it was not practical to correct the error prior to closing. Be that as it may, the fact is CHC paid for and obtained title to the shares. A taxpayer is to be taxed "based on what it actually did, not based on what it could have done": Shell, supra, page 5677.
[16] The purpose of the Appellant borrowing US$8.95 million was to finance the purchase of Viking by its parent CHC. The direct use of the funds was an interest free-loan to Holdings and this is an direct ineligible use.
[17] Having found there was a direct ineligible use, I must now consider the Appellant's alternative argument which is that the unique facts of this case are within the scope of the exceptional circumstances referred by Dickson C.J.C. dicta in Bronfman at page 5067 as follows:
... It is not lightly to be assumed that an actual and direct use of borrowed money is any less real than the abstract and remote indirect uses which have, on occasion, been advanced by taxpayers in an effort to achieve a favourable characterization....
... In my view, the text of the Act requires tracing the use of borrowed funds to a specific eligible use, its obviously restricted purpose being the encouragement of taxpayers to augment their income-producing potential. ...
Even if there are exceptional circumstances in which, on a real appreciation of a taxpayer's transactions, it might be appropriate to allow the taxpayer to deduct interest on funds borrowed for an ineligible use because of an indirect effect on the taxpayer's income-earning capacity, I am satisfied that those circumstances are not presented in the case before us. It seems to me that, at the very least, the taxpayer must satisfy the Court that his or her bona fide purpose in using the funds was to earn income. ...
[18] In 74712 Alberta Limited, supra, Robertson J. analyzed Dickson C.J.C.'s reference to "exceptional circumstances". Robertson J. at 5139 and 5140 concluded that "in certain circumstances interest payments may be deducted even though they are tied to a direct ineligible use of borrowed funds". He found there are two requirements (i) that the taxpayer establish a bona fide purpose (intention) to use the funds to earn income and (ii) a reasonable expectation that the borrowing transaction would yield income in excess of the interest expense.
[19] I find Shell to be of no assistance in determining whether or not a transaction is in the "exceptional circumstances" category because in Shell, the Supreme Court of Canada found that there was a direct eligible use and the Court made no reference to "exceptional circumstances".
[20] Dealing with the first criteria as stated, the Appellant's purpose of borrowing was to enable its corporate group to acquire the shares of Viking. There was conclusive evidence that the group's purpose in acquiring the shares was to increase the Appellant's income by charging Viking management fees for valuable services rendered. It is highly unlikely that this overriding purpose for the borrowing changed between August 25, 1989 and August 31, 1989 when CHC became the ultimate purchaser. The Appellant earned $2.5 million in management fees during the relevant years and paid $1.6 million in interest.
[21] The loan from the Appellant to its parent corporation was interest-free and without conditions. The Respondent's counsel argued that the Appellant had nothing to gain by granting the loan and that the Appellant could have demanded payment of the loan.
[22] I find this argument does not address Dickson C.J.C.'s indirect use of eligible funds. The reality is that the Appellant borrowed the money and in return received management fees far in excess of the interest paid. The Appellant borrowed the money and obtained a substantive benefit. These facts cannot be ignored. In fact, in 1996 the Viking operation was integrated with that of the Appellant.
[23] The second and more important requirement is whether the Appellant had a reasonable expectation that the transaction would yield income in excess of the interest expense.
[24] The Appellant reasonably expected earning management fees and the transfer to it of Viking's non-Quebec operations from which it anticipated $7 to $8 million of gross annual revenue. The indirect use was for an eligible use, to earn income. The interest constituted "interest on borrowed money used for the purpose of earning income from a business or property", within the meaning of paragraph 20(1)(c) of the Act.
Thailand Expenses
[25] In order to maintain its license to carry on business in Thailand,[1] the Appellant felt obliged to pay US$300,000 annually which ended in the hands of a local agent, who apparently had governmental influence. Without this payment, the license would not be renewed.
[26] The following is a summary of the evidence with respect to this expense:
i) There was an agreement for helicopter services between Thai Aviation Services Limited ("TASL") and Unocal Thailand Limited ("Unocal");
ii) During the period in question, the Appellant owned 10% of the outstanding shares of TASL;
iii) TASL owned a licence that allowed it to operate in Thailand;
iv) The Appellant paid US$300,000 annually to a law firm for deposit in the law firm's Hong Kong account; and
v) Some or all of the US$300,000 was paid to Mr. Pitak whose function appears to have been to first obtain TASL's licence and then to maintain it.
Position of the Appellant
[27] Business practices are different in Thailand than those in Canada yet the amount claimed is a deductible expense because it was necessary to earn income by retaining an attractive contract in Thailand. The evidence in this regard was uncontradicted.
[28] For unexplained reasons, the Appellant amortized these Thailand payments over a number of years. This practice is not in issue.
Position of the Respondent
[29] The payments were made to maintain the TASL license. TASL may be able to deduct the expense but not the Appellant. Counsel argued that TASL cannot be ignored as it was a separate legal entity. The Appellant was not in business in Thailand and TASL was. The contractual arrangements were between TASL and Unocal. Counsel added that one can characterize the Thailand payment as an expense of carrying on business but the business was that of TASL and not the Appellant.
Analysis
[30] I agree with the position of the Respondent. TASL owned the license to operate in Thailand. The Appellant was but a minority shareholder (10%) of TASL. The payments were made to protect TASL's license. The contract to earn business income in Thailand was between TASL and Unocal. The only way the Appellant could have earned income from the Thailand contract was to charge management fees or receive dividends from TASL and there is no evidence of this.
[31] I do not doubt that the Appellant paid US$300,000 annually to protect TASL's operating license but this was paid for TASL to earn business income, not the Appellant. If the Appellant is prepared to play according to Thailand rules or practices, it must be prepared to pay the price when Canadian law is applied.
[32] In conclusion, the appeals are allowed on the basis that in computing income for the 1990 and 1991 taxation years, the Appellant is entitled to deduct the interest claimed on money borrowed from US West Financial Services Limited, pursuant to paragraph 20(1)(c) of the Act. The Appellant having been substantially successful, is entitled to one set of costs and the Appellant is not entitled to any further relief.
Signed at Ottawa, Canada, this 9th day of April, 2001.
"C.H. McArthur"
J.T.C.C.
[1] The Appellant's helicopters were used by a US corporation in the oil business in the Sea of Siam.