Category Archives: Income/Capital

Professional Advice Capital v Income – Sas Ansari

Download PDF

Professional Advice –  Capital v Income 

Rio Tinto Alcan Inc v Canada, 2016 TCC 172

At issue was whether legal fees, investment banking fees, fees in respect of government representations, and other matters incurred at a time where take-overs and spin-offs were being conducted were  on account of capital (and added to the ACB of the shares) or income.

ANALYSIS

Although ITA subsection 9(1) allows for the deduction of expenses from revenue in determining profit, paragraphs 18(1)(a) and (b) limit deductions that may be claimed.  The outlay or expense must have been incurred for the purpose of gaining or producing income from a business (s 18(1)(a)), and cannot be an outlay or expense that is of a capital nature (s 18(1)(b)).

The respondent argued that the expenses were current expenses as they relate to the cost of professional advice relied on by the board of directors in deciding whether or not to approve the transactions – “oversight expenses” rather than “execution costs”.

What is meant by “on account of capital” as used in 18(1)(b) is not defined in the ITA.  No rigid or single test applies and the courts must draw the distinction on the facts of a particular case – Johns‑Manville Canada Inc. v. The Queen,[16]:

  • The matter turns on how the expenditure is calculated to effect from a practical and business point of view rather than based on juristic classification of the legal rights secured, employed or exhausted in the process (para 73);
  • The distinction draws a line between: (i) the acquisition of the means of production and the use of such means; (ii) establishing or extending a business organization and carrying on business; (iii) implements employed in work and the regular performance of work; (iv) the enterprise itself and the sustained effort of those engaged in the enterprise;
  • Other considerations include: (i) the character of the advantage sought and its lasting qualities; (ii) the recurrence of the expense; (iii) the manner in which the advantage is to be used or enjoyed; (iv) the means adopted to obtain the advantage;
  • The expense is on income account where the purpose of the expense which would fall into the class of thing that in aggregate are in constant demand;

The Court identified the three tests developed by the courts in distinguishing between capital and income:

  1. The recurring expense test – though just because an expense is made once and for all does not mean it is of capital nature (para 75);
  2. Enduring benefit or asset test – looks to whether the expenditure creates a lasting benefit for the business (para 76);
  3. Underlying Purpose or Rationale Test – if an expense is incurred to a matter related to the income earning process, it is likely current, while an expense incurred as part of the implementation of a transaction resulting in the creation or acquisition of a capital asset, or expansion of business, is likely on capital account (para 77) analyzed in the context of the taxpayer’s business with a view to the commercial purpose of the payment-  Ikea Ltd. v. Canada,  [1998] 1 S.C.R. 196; Morguard Corp. v. The Queen, 2012 FCA 306.

The tests above must be applied on a case-by-case basis and none alone provides a definitive answer in all circumstances (para 79).

Just because an expenditure was made as part of the decision-making process or oversight process of determining whether or not to bring about a capital asset does not make the expense one of capital nature.  These expenses may still result from the current operations of the business and part of the concern of directors and officers for conducting the daily operations in a business-like manner (para 80) – Bowater Power Co. Ltd. v. M.N.R., 71 DTC 5469; Wacky Wheatley’s TV & Stereo Ltd. v. M.N.R., 87 DTC 576; see also IT‑475 “Expenditures on Research and for Business Expansion.

The court noted that the current business environment demands greater oversight over activities of the corporation, with the board challenging and testing proposals by managers by, in part, seeking independent professional advice to guide their decision-making process (para 87).  The court held at paragraph 88:

Simply put, Oversight Expenses are current expenses because they relate to the management of a corporation’s income‑earning process. Proper management includes the judicious allocation or reallocation of capital for the purpose of maximizing the income earned by the corporation. Ineffective oversight over the capital allocation process is a formula for disaster that often leads to a decline in earnings and cash flow and, as a result, the destruction of shareholder value. In this context, Oversight Expenses serve an income‑earning purpose. Oversight Expenses per se do not create enduring benefits for taxpayers. Rather, it is the actual implementation of an approved capital transaction that creates the enduring benefit. In this context, the Court must carefully scrutinize the evidence, with proper regard to the applicable evidentiary burden, in order to ensure that the expenses that are treated by a taxpayer as current expenses actually pertain to advice given to the board of directors to assist it in the decision‑making process undertaken as part of the exercise of the board’s oversight function. This is to be contrasted with expenses incurred as part of the implementation of a transaction leading to the acquisition of capital property. In that context, the Court must look at the primary purpose of the work performed. Was the work commissioned primarily to assist in the oversight or management process, or was it primarily linked to the implementation of a transaction carried out on capital account?

Sas Ansari, BSc BEd PC JD LLM PhD (exp) CPA In-Depth Tax 1, 2 &3

If you like this website, please share it with others.

Back To Top OR Home

Currency Hedging – Gains Capital or Income?

Download PDF

Currency Hedging – Gains Capital or Income?

George Weston Limited v The Queen, 2015 TCC 42

At issue was whether the gains realised from the dissolution of a currency hedge were on account of capital or income.  The Court identified the defining characteristics of a “hedge”, and stated that the nature of hedge gains or losses is linked to the nature of the underlying item the risk of which is being hedged.

FACTS

The Appellants is a holding company parent of a number of operating subsidiaries, many of which are in the USA.  In order to protect itself against fluctuations of the US dollar in relation to the Canadian dollar (the currency in which it had to reports its financial statements in), the Appellant entered into currency swaps.  When the Canadian dollar rose in relation to the US, reaching parity, the swaps were terminated resulting in a gain of about 317 Million.

The Appellant took the position that this gain was on account of capital and only half included in income. The respondent took the position that the gain was on account of income and, therefore, fully included.

ANALYSIS

The Court determined that it was appropriate to admit expert evidence of a risk management person because (i) hedge is not defined in the ITA and in the context of this case it was appropriate to consider the commercial context of hedging, as “well-accepted principles of commercial trading are acceptable as guidance”: Symes v. Canada, [1993] 4 S.C.R. 695, and (ii) expert testimony on industry practice and on accounting principles related thereto are relevant:  Echo Bay Mines Ltd. v. Canada,  [1992] 3 F.C. 707.   Where a statutory definition is absent, the Courts should be careful to disregard the valuable guidance offered by well-established business principles: Canderel Ltd. v. Canada, [1998] 1 S.C.R. 147.

The Court moved on to define “hedge” and noted that the ITA does note provide a definition (other than in the context of weak currency debts in subsection 20.3(1), which provides indirect guidance). In subsection  20.3(1),  hedge is a derivative that is entered into primarily to reduce risk, where the derivative is properly designated as a hedge.  In Placer Dome Canada Ltd. v. Ontario (Minister of Finance), [2006] 1 S.C.R. 715, the SCC characterized hedging as referring to a transaction that offsets financial risk, and a transaction is a hedge where  the party to it genuinely has assets or liabilities exposed to market fluctuations, and not in an amount in excess of risk exposure (which indicated speculation).

Here the Court held that the swaps were entered into over a period and that this period  was close to the transaction dates that gave rise to the need to hedge against financial risk.  The court did not find a problem with a parent holding company entering into the swaps on behalf of its subsidiaries.

The Court distinguished Tip Top Tailors Ltd. v. Minister of National Revenue, [1957] S.C.R. 703 and Atlantic Sugar Refineries Ltd. v. Minister of National Revenue, [1949] S.C.R. 706, as both those cases involved earnings from derivatives linked to commodities used in the business of the taxpayer.  Here, the swaps were not the purchase or sale of commodities; rather they serve to stabilize the value of foreign currency assets exposed to currency risk on the company’s balance sheet (para 77).   The character of the hedge gain or loss depends on the characterization of the underlying item to which the hedge relates – the risk being hedged  (para 80).

It appears that the Court accepts a transaction to be a hedge where: (i) the transaction is recorded as a hedge in its financial statements for accounting and tax purposes; (ii) the transaction was not speculation ; and (iii) the amount of the hedge matches as closely as possible the amount of the financial risk being hedged against (Para 96).  Further, the character of the hedge gains or losses depend on the character of the underlying item being hedged – if the risk being hedged is capital in nature, the gain or loss from the hedging transaction will also be capital in nature (absent a secondary intention) (para 97).  The Court concluded, at paragraph 98:

[98]        In sum, the present case involves a situation that has not previously been brought before the courts, at least that I am aware of. The appellant made a commercial and business decision, after careful consideration, to enter into the swaps in order to protect its consolidated group equity. It knew better than anyone else the consequences of having its net investment assets exposed to the risk of currency fluctuations. The swaps are commercial derivatives designed expressly to circumvent that kind of risk. As stated by Ms. Frost, the swaps were not speculative transactions. They were designed for hedging in the financial market. Now when the risk vanished, there was no need to keep the swaps. Here, GWL was satisfied that the swaps were no longer necessary when the risk exposure of the net investment assets was reduced significantly. They therefore decided to unwind the swaps. I have concluded that the swaps were entered into to protect a capital investment, and therefore they were linked to a capital asset. Absent unacceptable risk with regard to those capital assets, the swaps had to be terminated since the reason for their existence no longer applied, and the gain or loss from unwinding the swaps should, in my view, be treated as being on capital account. The swaps were not linked in any manner to any business income per se.

The Court rejected the Crown’s alternative argument that the gain was from an adventure or concern in the nature of trade, by referring to the factors that determine whether an adventure is an adventure or concern in the nature of trade in Belcourt Properties Inc. v. The Queen, 2014 TCC 208, and  Happy Valley Farms Ltd. v. The Queen, [1986] 2 C.T.C. 259.  Having rejected the existence of an initial and/or secondary intention to enter into a profit making scheme, the transaction failed to meet this test.

Sas Ansari, BSc BEd PC JD LLM PhD (exp) CPA In-Depth Tax 1, 2 &3

If you like this website, please share it with others.

Back To Top OR Home