Interpretation of Contracts in Tax Cases – River Hills Ranch

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Principles to Apply in Interpreting a Contract – Use of External Evidence

River Hills Ranch Ltd v The Queen, 2013 TCC 248

The main issue in the appeal was whether a payment received was on account of capital or income.

The case is also interesting in reviewing the principles to be applied in interpreting a contact for tax purposes.

FACTS

The taxpayers were contracted to collect Pregnant Mare Urine for a company, but these agreements were terminated early and a payment made on account of the termination in exchange for a release form the taxpayers.  The release divided the payment into two portions, one portion stated to be as part of the feed and herd health (which required keeping the horses for a specified period of time).

The court stated that “the termination of the agreement resulted in the complete cessation” of the taxpayers’ urine collection business.

Appellant’s Argument

The taxpayer argued that the payments under the release were meant to compensate them for losses of their business, and therefore were on capital account.  They argued that despite a portion being for feed and health, in fact these were disguised termination payments.  The taxpayer relied on: BP Canada Energy Resources Company v. The Queen (“BP Canada”), 2002 DTC 2110, Canadian National Railway Company v. M.N.R., 88 DTC 6340, and Pe Ben Industries Company Limited v. The Queen, 88 DTC 6347.

Respondent’s Argument

The Crown argued that the feed and health payments were an allowance for anticipated expenses (cover ongoing operation expenses), and therefore on account of income.

COURT’S ANALYSIS

The court began by reviewing the general principles of contractual interpretation by reference to Ventas, Inc. v. Sunrise Senior Living Real Estate Investment Trust. Quoting the application judge, 2007 ONCA 205, at para. 24, Blair J.A. noted:

. . . Broadly stated . . . a commercial contract is to be interpreted,

(a)  as a whole, in a manner that gives meaning to all of its terms and avoids an interpretation that would render one or more of its terms ineffective;

(b)  by determining the intention of the parties in accordance with the language they have used in the written document and based upon the “cardinal presumption” that they have intended what they have said;

(c)  with regard to objective evidence of the factual matrix underlying the negotiation of the contract, but without reference to the subjective intention of the parties; and (to the extent there is any ambiguity in the contract),

(d) in a fashion that accords with sound commercial principles and good business sense, and that avoid a commercial absurdity.

[Emphasis added; footnotes omitted.]

The court then referred to the “Parole Evidence” Rule which prevents the reference to extrinsic evidence so as to “alter, vary, or interpret in any way the words used in writing”, so as to prevent “the use of fabricated or unreliable extrinsic negotiations to attack formal written contracts”, The Law of Contract in Canada, 6th ed. (Toronto: Carswell, 2011) at p. 440-42.

However, the parole evidence ruled does not apply where extrinsic evidence is required to dispel ambiguities.  Where an agreement is clear and unambiguous on its face, extrinsic evidence is not permitted; Eli Lilly and Co. v. Novopharm Ltd. (“Eli Lilly”), [1998] 2 S.C.R. 129, paragraphs 54-55.  Ambiguity must be found in the document itself and cannot be ambiguity created by the extrinsic evidence presented by the parties; The Queen v. General Motors (“GM”), 2008 FCA 142; see also On-Line Finance & Leasing Corp. v. The Queen. 2010 TCC 117.

The position in GM has been modified:

[42] […] Doherty J.A. of the Ontario Court of Appeal, having referred to Lord Hoffmann’s opinion in Investors Compensation Scheme Ltd v. West Bromwich Building Society, [[1998] 1 All E.R. 98] noted that the “meaning of [a] written agreement must be distinguished from the dictionary and syntactical meaning of the words used in the agreement”. According to Doherty J.A., while the plain meaning of the words “will be important and often decisive in determining the meaning of the document”, a “consideration of the [“objective contextual scene”] [2007 ONCA 59] in which the written agreement was made is an integral part of the interpretative process and is not something that is resorted to only where the words viewed in isolation suggest some ambiguity.

[43]        Prior to Dumbrell, Goudge J.A. of the Ontario Court of Appeal had also noted that courts can use extrinsic evidence in taking into account the “factual matrix” of an agreement in cases where there is no ambiguity. [Kentucky Fried Chicken Canada, a Division of Pepsi-Cola Canada Ltd. v. Scotts’ Food Services Inc., [1998] O.J. No. 4368 (QL) (ON CA)] He indicated that the factual matrix of an agreement includes to the genesis of the agreement, its purpose, and the commercial context in which it was made. In so doing, he relied on the following observations by Lord Wilberforce of the House of Lords in Reardon Smith Line Ltd. v. Yngvar Hansen-Tangen: [[1976] 1 W.L.R. 989 at 995-96 (H.L.).]

No contracts are made in a vacuum: there is always a setting in which they have to be placed. The nature of what is legitimate to have regard to is usually described as “the surrounding circumstances” but this phrase is imprecise: it can be illustrated but hardly defined. In a commercial contract it is certainly right that the court should know the commercial purpose of the contract and this in turn presupposes knowledge of the genesis of the transaction, the background, the context, the market in which the parties are operating.

[44]        These two decisions (Dumbrell and KFC) suggest that a distinction must be made between the case where extrinsic evidence is admissible for the purpose of resolving an ambiguity – a notable exception to the parol evidence rule – and the case in which such evidence is considered for the purpose of giving meaning to the terms and conditions of an agreement in light of the “surrounding circumstances” or the factual matrix of the agreement. In the latter case, no ambiguity need exist. The respondent, in her written submissions, cites Gilchrist v. Western Star Trucks, a case in which this distinction is recognized in the following terms:

The goal in interpreting an agreement is to discover, objectively, the parties’ intention at the time the contract was made. The most significant tool is the language of the agreement itself. This language must be read in the context of the surrounding circumstances prevalent at the time of contracting. Only when the words, viewed objectively, bear two or more reasonable interpretations, may the court consider other matters such as the post-contracting conduct of the parties . . . .

The Court agreed that the inconsistencies in the agreement would cause a reader to question the intent and purpose of the payments in question, thus requiring analysis of extrinsic evidence.  However, evidence as to the subjective intention of the parties or their own understanding is not admissible (paragraph 52).  The court received the extrinsic evidence because the evidence “pertains to the factual matrix or circumstances surrounding the Release and/or because the FHH payment clauses are ambiguous in light of the inconsistencies noted earlier” (paragraph 59).

The Court concluded that the Feed and health payments were disguised payments to compensate for the destruction of the business, whose capital assets became worthless as capital assets upon the termination of the agreement. Thus, the payments gave rise to capital gains and not income.

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