Canada v. McLarty

Canada v. McLarty
Collection
Supreme Court Judgments
Date
2008-05-22
Neutral citation
2008 SCC 26
Report
[2008] 2 SCR 79
Case number
31516
Judges
McLachlin, Beverley; Bastarache, Michel; Binnie, William Ian Corneil; LeBel, Louis; Deschamps, Marie; Fish, Morris J.; Abella, Rosalie Silberman; Charron, Louise; Rothstein, Marshall
On appeal from
Federal Court of Appeal
Subjects
Taxation
Notes
SCC Case Information: 31516
Decision Content
SUPREME COURT OF CANADA
Citation: Canada v. McLarty,
[2008] 2 S.C.R. 79, 2008 SCC 26
Date: 20080522
Docket: 31516
Between:
Her Majesty The Queen
Appellant / Respondent on cross‑appeal
and
Allan McLarty
Respondent / Appellant on cross‑appeal
Coram: McLachlin C.J. and Bastarache, Binnie, LeBel, Deschamps, Fish, Abella, Charron and Rothstein JJ.
Reasons for Judgment:
(paras. 1 to 76)
Joint Reasons
Dissenting in Part:
(paras. 77 to 92)
Rothstein J. (McLachlin C.J. and Binnie, LeBel, Deschamps, Fish and Charron JJ. concurring)
Bastarache and Abella JJ.
______________________________
Canada v. McLarty, [2008] 2 S.C.R. 79, 2008 SCC 26
Her Majesty The Queen Appellant/Respondent on cross‑appeal
v.
Allan McLarty Respondent/Appellant on cross‑appeal
Indexed as: Canada v. McLarty
Neutral citation: 2008 SCC 26.
File No.: 31516.
2008: January 28; 2008: May 22.
Present: McLachlin C.J. and Bastarache, Binnie, LeBel, Deschamps, Fish, Abella, Charron and Rothstein JJ.
on appeal from the federal court of appeal
Taxation — Income tax — Computation of income — Deductions — Canadian exploration expenses — Absolute or contingent liability — Limited recourse debt — Arm’s length transaction — Taxpayer purchasing interest in proprietary seismic data as participant in oil and gas joint venture — Interest acquired for $100,000, satisfied by cash of $15,000 and promissory note of $85,000, payable at future date — Taxpayer deducting $81,655 from income as Canadian exploration expense in 1992 and additional $14,854 in 1994 — Minister reassessing deductions on basis that seismic data had fair market value of $32,182, not $100,000 — Whether taxpayer’s liability under promissory note absolute or contingent — Whether taxpayer’s purchase transaction was at arm’s length — Income Tax Act, R.S.C. 1985, c. 1 (5th Supp .), ss. 66.1(6) “Canadian exploration expense” (a), 69(1)(a), 251(1).
On December 31, 1992, M purchased from C, an oil and gas exploration and development corporation, an interest in proprietary seismic data, as a participant in an oil and gas joint venture. M acquired a 1.57% interest in the data for the price of $100,000, satisfied by cash of $15,000 and a promissory note of $85,000 payable with interest to C on December 31, 1999. The principal and interest was to be paid from 60% of the cash proceeds received from any future sales or licensing of the seismic data and from 20% of the production cash flow generated from petroleum rights from the drilling programs. The note also provided that, should any principal or interest remain unpaid at the maturity of the note, a trustee was to be appointed to sell the seismic data with the proceeds of sale being allocated 60% in reduction of amounts owing under the note and 40% to M. On December 31, 2001, M signed an acknowledgment whereby C agreed to extend the due date of the promissory note to December 31, 2002. On filing his income tax return for 1992, M treated his purchase of seismic data as a Canadian exploration expense and added $100,000 to his cumulative Canadian exploration expense pool. In calculating his income, he deducted $81,655 as a Canadian exploration expense in 1992, and an additional $14,854 in 1994, reducing his pool accordingly. The Minister reassessed M on the basis that the seismic data had a fair market value of $32,182, not $100,000. M challenged the reassessment. The Tax Court found that M was entitled to a $100,000 deduction. The Federal Court of Appeal set aside the decision, concluding that M was not dealing with C at arm’s length, and remitted the matter to the Tax Court for a determination of whether the fair market value of the seismic data exceeded $32,182.
The issue on the appeal before this Court is whether M’s liability under the promissory note was absolute or contingent. Under s. 66.1(6) of the Income Tax Act , the deduction for Canadian exploration expenses is available only to taxpayers who have made themselves absolutely liable. On the cross‑appeal, the issue is whether M was dealing with C at arm’s length. Where parties are found not to be dealing at arm’s length, the taxpayer who has made an acquisition is deemed to have made the acquisition at fair market value.
Held (Bastarache and Abella JJ. dissenting on the appeal): The appeal should be dismissed and the cross‑appeal allowed. The trial judge’s decision should be restored.
Per McLachlin C.J. and Binnie, LeBel, Deschamps, Fish, Charron and Rothstein JJ.: Under s. 66.1(6) of the Income Tax Act , a taxpayer may take a deduction where he has incurred an expense and, generally, a taxpayer incurs an expense when he has a legal obligation to pay a sum of money. In this case, M is entitled to a deduction of $100,000 as a Canadian exploration expense under s. 66.1(6) because he has incurred an expense. The test for a contingent liability defines a contingency as an event which may or may not occur, and a contingent liability as a liability which depends for its existence upon an event which may or may not happen. The test is simply whether a legal obligation comes into existence at a point in time or whether it will not come into existence until the occurrence of an event which may never occur. Here, on December 31, 1992, M agreed to pay $85,000 together with interest at 8%. The obligation to repay the principal and the interest under the note came into existence at that time. There was no certainty that there would be future sales or licensing of the seismic data, nor was there certainty that there would be production cash flow from petroleum rights from drilling programs. Were these the only conditions upon which the note would be repaid, the liability would be contingent. However, the note provided that should any amount be outstanding at maturity, C would have recourse to the security, that is, the data acquired by M. Events are not uncertain at maturity. The terms of the promissory note demonstrate that M’s liability was absolute, not contingent. The fact that the value of the collateral security at maturity may not be sufficient for the creditor to make full recovery does not make the liability contingent. Nor does the fact that the amount that will be paid at the end of the day is uncertain. The present case involves limited recourse debt and a creditor’s limited recourse on default of a debt cannot make an otherwise absolute liability contingent, nor can it turn an otherwise contingent obligation into one that is absolute. In other words, the extent of recourse has no bearing on the question of whether a liability is absolute or contingent. The Minister’s arguments against absolute liability do identify uncertainties, but they are not uncertainties based on whether a future event will or will not occur and, therefore, they do not meet the test for contingent liability.
[9] [14] [17‑18] [24‑25] [27] [29‑31] [33] [39]
There was no basis to interfere with the trial judge’s findings that M’s dealings with C were at arm’s length. The parties in this case were not related and it is a question of fact whether they were dealing at arm’s length. With respect to the purchase of the seismic data, the appropriate relationship to assess was that between C and M. While the initial focus is on the transaction between C as vendor and C as purchasing agent for the joint venture participants, all the relevant circumstances must be considered to determine if M was dealing with the vendor at arm’s length. Here, the trial judge applied the relevant indicia for identifying dealings not at arm’s length and found that C and its principal did not influence M’s decision to invest, there was no evidence that C and M acted in concert without separate interests, and no party had the power to impose its will on the other. The trial judge also placed significance on the limitations imposed on the purchase transaction by the Offering Memorandum, which limited the purchase price to not higher than the lowest valuation. It was appropriate for the trial judge to have considered the entirety of the transactions by which M bound himself to purchase his interest in the seismic data and place limitations on C as his agent with respect to the purchase price of the data. It was for the trial judge to draw inferences from these facts. In the absence of palpable and overriding error, the Federal Court of Appeal was in error in interfering with the conclusion of the trial judge. [45] [54] [61] [63] [68] [70] [73] [75]
Per Bastarache and Abella JJ. (dissenting on the appeal): The transaction occurred at arm’s length, but M’s promissory note is a contingent liability and therefore does not meet the requirements of s. 66.1(6) of the Income Tax Act . M’s liability depends on whether the business venture generates revenues. Whether it will do so is uncertain. This in turn makes the liabilities that depend on revenue generation uncertain and, accordingly, contingent. Under the terms of the note, M would never be personally liable for the $85,000. C would only receive the full amount if the venture proved sufficiently profitable (or the data, on resale, sufficiently valuable) to cover the debt. Moreover, the terms of the note specify that M would only be obliged to repay 60% of the sold data and that any balance owing after the allocation of the proceeds would be forgiven. This cannot be equated to an absolute liability to pay $85,000. M may eventually claim a tax deduction if he pays C some amount under the promissory note. But until he incurs the expense, it is difficult to see his liability as anything other than contingent. [79] [86] [89‑91]
Cases Cited
By Rothstein J.
Distinguished: Global Communications Ltd. v. The Queen, 99 D.T.C. 5377; referred to: Wawang Forest Products Ltd. v. The Queen, 2001 D.T.C. 5212, 2001 FCA 80; Winter v. Inland Revenue Commissioners, [1963] A.C. 235; Mandel v. The Queen, [1979] 1 F.C. 560, aff’d [1980] 1 S.C.R. 318; Hill v. The Queen, 2002 D.T.C. 1749; Swiss Bank Corp. v. M.N.R., [1974] S.C.R. 1144; Peter Cundill & Associates Ltd. v. Canada, [1991] 1 C.T.C. 197, aff’d [1991] 2 C.T.C. 221.
By Bastarache and Abella JJ. (dissenting on the appeal)
Wawang Forest Products Ltd. v. The Queen, 2001 D.T.C. 5212, 2001 FCA 80; J. L. Guay Ltée v. M.N.R., 75 D.T.C. 5094, aff’g [1973] C.T.C. 506, aff’g [1971] C.F. 237; Winter v. Inland Revenue Commissioners, [1963] A.C. 235; Mandel v. The Queen, [1980] 1 S.C.R. 318, aff’g [1979] 1 F.C. 560, aff’g [1977] 1 F.C. 673.
Statutes and Regulations Cited
Income Tax Act, R.S.C. 1985, c. 1 (5th Supp .), ss. 66.1(6) “Canadian exploration expense” (a), 69(1)(a), 251(1).
Authors Cited
CCanada. Canada Revenue Agency. Interpretation Bulletin IT‑419R2, “Meaning of Arm’s Length”, June 8, 2004.
Hogg, Peter W., Joanne E. Magee and Jinyan Li. Principles of Canadian Income Tax Law, 6th ed. Toronto: Thomson/Carswell, 2007.
APPEAL and CROSS‑APPEAL from a judgment of the Federal Court of Appeal (Sexton, Evans and Malone JJ.A.), [2006] 4 C.T.C. 16, 348 N.R. 90, 2006 D.T.C. 6340, [2006] F.C.J. No. 656 (QL), 2006 CarswellNat 1096, 2006 FCA 152, setting aside an order of Little J., [2005] 1 C.T.C. 2875, 2005 D.T.C. 217, [2005] T.C.J. No. 42 (QL), 2005 CarswellNat 127, 2005 TCC 55. Appeal dismissed, Bastarache and Abella JJ. dissenting. Cross‑appeal allowed.
Wendy Burnham and Pierre Cossette, for the appellant/respondent on cross‑appeal.
Jehad Haymour, Carman R. McNary and Peter D. Banks, for the respondent/appellant on cross‑appeal.
The judgment of McLachlin C.J. and Binnie, LeBel, Deschamps, Fish, Charron and Rothstein JJ. was delivered by
Rothstein J. —
I. Introduction
[1] The issue in this appeal is whether a liability is absolute or contingent. In the circumstances of this appeal, if it was absolute, it could be deducted as an expense for income tax purposes. If it was contingent, it could not.
[2] The issue in the cross-appeal is whether, in acquiring an asset, the purchaser was dealing with the vendor at arm’s length. If he was, the purchase price of the asset could be deducted as an expense for income tax purposes. If he was not, the Minister of National Revenue was entitled to reassess on the basis of the fair market value of the asset. In that case, it would only be the fair market value that could be deducted as an expense for income tax purposes.
[3] In my opinion, the appeal should be dismissed and the cross-appeal allowed.
II. Facts
[4] On December 31, 1992, the respondent, Allan McLarty, purchased from Compton Resource Corporation (“Compton” or “CRC”) an interest in proprietary seismic data as a participant in an oil and gas joint venture, the CRC 1992/1993 Oil and Gas Investment Fund.
[5] McLarty acquired a 1.57% interest in the data for the price of $100,000, satisfied by cash of $15,000 and a promissory note of $85,000 payable with interest to Compton on December 31, 1999.
[6] On December 31, 2001, McLarty signed an acknowledgment whereby Compton agreed to extend the due date of the promissory note to December 31, 2002.
[7] As of the end of 2001, the balance owing on the promissory note was $93,242.
[8] On filing his income tax return for 1992, McLarty treated his purchase of seismic data as Canadian exploration expense (“CEE”) and added $100,000 to his cumulative Canadian exploration expense pool. In calculating his income, he deducted $81,655 as CEE in 1992, and an additional $14,854 in 1994, reducing his pool accordingly. The Minister reassessed McLarty on the basis that the seismic data had a fair market value of $32,182, not $100,000.
[9] The issues at trial were:
1. Whether McLarty’s purchase of the seismic data was for the purpose of exploration for petroleum or natural gas as required by s. 66.1(6) of the Income Tax Act, R.S.C. 1985, c. 1 (5th Supp .).
2. Whether McLarty’s liability under the promissory note was absolute or contingent.
3. Whether, in purchasing the seismic data, McLarty was dealing with the vendor, Compton, at arm’s length.
4. If the dealing was not at arm’s length, was the fair market value of the seismic data in excess of $32,182?
5. Whether a deduction in excess of $32,182 was reasonable.
The trial judge found in favour of McLarty on all issues entitling him to a deduction of $100,000 ([2005] 1 C.T.C. 2875, 2005 TCC 55).
[10] Except for the issue of whether a deduction in excess of $32,182 was reasonable, which was not appealed, the Federal Court of Appeal dealt with the remaining four issues ([2006] 4 C.T.C. 16, 2006 FCA 152). It found in favour of McLarty on the issue of the business purpose of the purchase and on the issue of the nature of the liability. However, it found that McLarty was not dealing with Compton at arm’s length. It therefore allowed the appeal and remitted the matter to the Tax Court for a determination of whether the fair market value of the seismic data exceeded $32,182.
[11] Before this Court, the only issues are whether McLarty’s liability under the promissory note was absolute or contingent and whether McLarty was dealing with Compton at arm’s length. I deal first with the absolute/contingent liability issue.
III. Provisions Under Which McLarty Claimed a Deduction
[12] Section 66.1(6) of the Income Tax Act defines a Canadian exploration expense. The definition provides in relevant part:
“Canadian exploration expense” of a taxpayer means any expense incurred . . . that is
(a) any expense including a geological, geophysical or geochemical expense incurred by the taxpayer . . . for the purpose of determining the existence, location, extent or quality of an accumulation of petroleum or natural gas . . . in Canada,
[13] An expense that qualifies as CEE is included in a taxpayer’s “cumulative Canadian exploration expense” pool that can be deducted in full in the year the expense was incurred or carried forward for deduction when needed. Unlike many business expenses under the Income Tax Act , CEE is not tied to the source of the income in relation to which the expense is incurred, but may be deducted from any income of the taxpayer.
IV. Analysis
A. Was the Appellant’s Liability Absolute or Contingent?
1. Definition of a Contingent Liability
[14] As explained by Sharlow J.A. in Wawang Forest Products Ltd. v. The Queen, 2001 D.T.C. 5212, 2001 FCA 80, at para. 9, generally a taxpayer incurs an expense when he has a legal obligation to pay a sum of money. In the present case, in addition to his cash payment of $15,000, McLarty signed a promissory note for $85,000 on December 31, 1992 and deducted $81,655 in 1992 and a further $14,854 in 1994. He could only deduct amounts in excess of his cash payment if the note for $85,000 constituted an expense incurred under s. 66.1(6) .
[15] The Minister says the note for $85,000 was a contingent liability and was therefore not an expense incurred in 1992. McLarty says the obligation he incurred on signing the note was absolute and therefore was an expense incurred under s. 66.1(6) in 1992.
[16] It is agreed that the expense will have been incurred if the liability is absolute and not if it is contingent.
[17] The well-accepted test for a contingent liability was described by Lord Guest in Winter v. Inland Revenue Commissioners, [1963] A.C. 235 (H.L.), at p. 262:
I should define a contingency as an event which may or may not occur and a contingent liability as a liability which depends for its existence upon an event which may or may not happen.
The focus is therefore on two particular types of uncertainty: (1) whether an event may or may not occur; and (2) whether a liability depends for its existence upon whether that event may or may not happen.
[18] What constitutes a contingent liability was further clarified by Sharlow J.A. in Wawang, at para. 15. By themselves, three uncertainties will not determine whether a liability is contingent. I paraphrase her reasons as follows:
a. Uncertainty as to whether the payment will be made. For example, a liability may be incurred when the taxpayer is in financial difficulty and there is a significant risk of non-payment. That does not mean the obligation was never incurred;
b. Uncertainty as to the amount payable. There is always uncertainty as to the amount that may be payable. There is never certainty that the borrower will be able to pay the amount owing when the note comes due. That type of uncertainty does not make a liability contingent;
c. Uncertainty as to the time by which payment shall be made. An obligation is not contingent because payment may be postponed if certain events occur.
The test is simply whether a legal obligation comes into existence at a point in time or whether it will not come into existence until the occurrence of an event which may never occur.
2. Is the Liability in This Case Absolute or Contingent?
[19] To determine the answer to this question, it is necessary to have regard to the terms of the promissory note signed by McLarty on December 31, 1992.
[20] The promissory note signed by McLarty was payable to Compton Resource Corporation. It reads as follows:
The undersigned, FOR VALUE RECEIVED, hereby promises to pay to COMPTON RESOURCE CORPORATION (the “Noteholder”) on the 31st day of December, 1999, the sum of eighty-five thousand ($85,000) in lawful money of Canada together with any accrued and unpaid interest on any unpaid portion of the said principal sum, which interest shall accrue from and after December 31, 1992, at the rate of eight percent (8%) per annum calculated annually and not in advance.
The terms of repayment of this promissory note to the Noteholder shall be limited to those terms set out herein and no other action shall lie against the undersigned in respect of any covenant for payment.
The indebtedness of the undersigned shall be reduced only in accordance with the provisions set forth in Schedule 1 attached hereto, which schedule is incorporated into and forms part of this promissory note.
This promissory note shall be non-negotiable and non-assignable by the Noteholder without the prior written consent of the undersigned and the assignee first agreeing in writing with the undersigned to be bound by the terms hereof. The Noteholder shall have no right of recourse against any legal person other than the undersigned in respect of the covenants contained herein and shall further have no greater rights hereunder than as are conferred hereunder and in Schedule 1 attached hereto.
DATED this 30th day of December, 1992.
[21] The terms of repayment of principal and interest were set out in Schedule 1 to the promissory note, the relevant portions of which provide:
2. The undersigned hereby assigns to the Noteholder, in reduction of the undersigned’s indebtedness under this promissory note, sixty (60%) percent of the cash proceeds received from any future sales or licensing net of commission of the Technical Assets (such 60% hereinafter referred to as the “Seismic Proceeds”).
3. In addition to the provisions of Section 2, the undersigned hereby assigns to the Noteholder, in reduction of the undersigned’s indebtedness under this promissory note, twenty (20%) percent of the Production Cash Flow generated by the undersigned’s Participating Interest in Petroleum Rights acquired by the Joint Venture pursuant to the Drilling Program (such 20% hereinafter referred to as the “Drilling Proceeds”).
4. The Seismic Proceeds and the Drilling Proceeds assigned pursuant to the provisions of Sections 2 and 3 hereof shall be used by the Noteholder to pay down the interest accrued under this promissory note on a monthly basis and when such amounts assigned exceed such interest accrued thereof, the excess shall be applied to the principal amount outstanding under this promissory note. The provisions of Sections 2 and 3 and the rights of the Noteholder under such provisions shall, notwithstanding any other provisions of this agreement, wholly terminate on the earlier of the date upon which this promissory note is retired or the indebtedness hereunder is otherwise extinguished.
5. The undersigned hereby grants a security interest in the Technical Assets to secure the undersigned’s liability to the Noteholder under this promissory note.
6. To the extent there is interest outstanding on this promissory note, the Noteholder’s remuneration under the Joint Venture Agreement will be credited against this interest obligation on a monthly basis.
7. If the indebtedness created hereby either with respect to principal or interest remains in whole or in part unpaid as of December 31, 1999, the Noteholder will appoint an independent trustee to sell for cash only:
a. the Technical Assets; and
b. an undivided 20% of the undersigned’s Participating Interest in Petroleum Rights acquired by the Joint Venture pursuant to the Drilling Program.
The proceeds of the sale will be allocated as follows:
a. Technical Assets:
i. 60% (net of commissions, if any) to the Noteholder as a reduction of amounts owing by the undersigned under this promissory note; and
ii. 40% (net of commissions, if any) to the undersigned;
b. an undivided 20% of the undersigned’s Participating Interest in Petroleum Rights acquired by the Joint Venture pursuant to the Drilling Program:
100% to the Noteholder as a reduction of amounts owing by the undersigned under this promissory note, allocated firstly as to interest and the remainder as to principal.
Any balance owing by the undersigned on this note after the allocation of the proceeds of the sale as described above will be forgiven by the Noteholder and the undersigned will have no further liability under this promissory note.
[22] On its face, the note is for $85,000 plus interest at 8% per annum and it is due on December 31, 1999. Without more, the promissory note constitutes an absolute liability. However, the note is subject to other terms.
[23] Section 2 of Schedule 1 to the note provides that 60% of the cash proceeds received from any future sales or licensing of technical assets is assigned to Compton. Section 3 provides that 20% of the production cash flow generated from petroleum rights from drilling programs is assigned to Compton.
[24] There is no certainty that there will be future sales or licensing of technical assets, nor is there certainty that there will be drilling programs or that there will be production cash flow from petroleum rights from drilling programs. Were these the only conditions upon which the note would be repaid, the liability would be contingent, because repayment was predicated on events which may or may not occur (see Mandel v. The Queen, [1979] 1 F.C. 560 (C.A.), aff’d [1980] 1 S.C.R. 318).
[25] However, events are not uncertain at maturity. Section 7 provides that, should any principal or interest remain unpaid at the maturity of the note, a trustee is to be appointed to sell the seismic data with the proceeds of sale being allocated 60% in reduction of amounts owing under the note and 40% to McLarty.
[26] The Minister relies on the decision of the Federal Court of Appeal in Global Communications Ltd. v. The Queen, 99 D.T.C. 5377, that in circumstances similar to the ones in this case, the liability was found to be contingent. However, as the Court of Appeal in this case pointed out, it does not appear that in Global the court took account of the fact that on maturity of the note there was recourse to the asset pledged as security for repayment. With respect, the decision in Global does not take account of all the terms of the note in that case and is not authoritative in circumstances such as in the case now before this Court.
[27] On December 31, 1992, McLarty agreed to pay $85,000 together with interest at 8%. The obligation to repay the principal and the interest under the note came into existence at that time. The note provided that, should any amount be outstanding at maturity, Compton would have recourse to the security, that is, the data acquired by McLarty. I agree with the Court of Appeal that the terms of the note demonstrate that McLarty’s liability was absolute and not contingent.
[28] In the Tax Court, Little J. found that there was an ongoing market for seismic data and that therefore the asset acquired by McLarty could be sold. While difficult to envision, perhaps if there was a serious question of whether the asset could be sold, it might be necessary to consider whether there was a market for such property. But I do not understand the Minister to argue that the asset might not be able to be sold. Indeed the Minister found there was a fair market value for the data and by necessary implication a market for its sale. Once the Minister conceded that the asset had a fair market value, it was unnecessary for Little J. to have considered whether there was a market for the seismic data.
3. Minister’s Arguments
[29] The present case involves limited recourse debt. In the context of debt, recourse means that the creditor has a right to repayment of a loan from the borrower, not just from the collateral that secured the loan. By contrast, non‑recourse or limited recourse debt limits the creditor to recovery of specified security. The creditor is not entitled to seek repayment from the borrower should the proceeds from the disposition of the security be less than the total indebtedness.
[30] The Minister and McLarty agree, as do I, that a creditor’s limited recourse on default of a debt cannot make an otherwise absolute liability contingent, nor can it turn an otherwise contingent obligation into one that is absolute. In other words, the extent of recourse has no bearing on the question of whether a liability is absolute or contingent.
[31] Nonetheless, the nature of the Minister’s arguments are, in my respectful view, based on the promissory note in this case being non-recourse. For example, the Minister says that “[a]n expense requires that there be certainty of quantum” and that the amount payable must be certain (Minister’s factum, at para. 24). In making this argument, the Minister is focussing on the fact that the proceeds of the sale of the asset may not be sufficient to repay the outstanding amount of principal and interest under the note at maturity. However, on December 31, 1992, an obligation to repay $85,000 plus interest was incurred. The fact that the amount that will be paid at the end of the day is uncertain does not make the liability contingent.
[32] In oral argument, Minister’s counsel agreed that if security in the form of a government bond worth $85,000 was pledged with no other recourse to the debtor, the obligation would be absolute. However, if stock worth $85,000 was pledged with no other recourse to the debtor and the price of the stock went down such that it was only worth $40,000 when the note matured, the obligation would be contingent.
[33] The Minister seems to be saying that if there is risk to the value of the collateral security at maturity, liability is contingent because the creditor may not make full recovery of the total liability. If the Minister were correct, all liability would be contingent. Although highly unlikely, even a government might default on a bond. And even in the case of a loan with full recourse to the debtor, there can never be absolute certainty that full repayment will always be made. The debtor may go bankrupt. But that does not make the liability contingent. It is inherent in a promissory note that there is a risk of non-payment. Indeed, interest rates are determined, in part, on the risk that repayment will not be made.
[34] What is at the root of the Minister’s difficulty in this case is that the Minister believes the price of the asset McLarty acquired was overvalued and that the data, as the only collateral security, was insufficient to cover repayment of the note. In fact, in January 2006, McLarty’s 1.57% interest in the seismic data was sold through an independent receiver for approximately $17,600 of which 60% or only about $10,500 was used to repay the note. There are remedies for the Minister where assets are overvalued solely to obtain a tax advantage. Trying to characterize the loan portion of the purchase price as contingent in this case was not one of them.
[35] The Minister says that the requirement to surrender assets does not make the liability to repay $85,000 absolute. Again this is an attack on non-recourse debt. Just as in the case of a mortgage foreclosure where there is a certainty of sale and proceeds from that sale and recourse is limited to those proceeds, here there is a certainty that the asset will be sold and a fixed percentage of the proceeds will be available to repay the loan (see Hill v. The Queen, 2002 D.T.C. 1749 (T.C.C.), at para. 37). The only uncertainty, as in the case of a mortgage foreclosure, is as to the amount of the proceeds from the sale. However, that does not make the liability contingent.
[36] The Minister argues that the mortgage foreclosure cases are distinguishable because the foreclosure only occurs once there is default under the mortgage whereas here, sale of the asset occurs as a term of the promise to repay. I must admit to not being able to appreciate the difference. Whether there is default because terms of repayment are breached or whether interim payments are not made because certain events do not occur, the result in each case is that the creditor looks to the collateral that secures the debt to satisfy the amount outstanding.
[37] The Minister says that until the proceeds of the sale of the security are ascertained, McLarty has only a liability “to become subject to an obligation to pay” (Minister’s factum, at para. 36). This again is an argument that the quantum of repayment must be certain in order for a liability not to be contingent. This is just another way of attacking non-recourse debt and looking at the value of security to test whether the liability was contingent or absolute. That is not the test for contingent liability. As already explained, there will always be uncertainty about the amount that will be repaid.
[38] The note provides that if any balance is owing after allocation of the proceeds of the sale of the security, the balance “will be forgiven by the Noteholder and the undersigned will have no further liability under this promissory note”. If the liability in this case was contingent upon the happening of a future event and the event did not occur, there would be no surviving liability and nothing to forgive. A forgiveness provision in a promissory note implies there is something to forgive, namely the absolute obligation that was initially incurred.
[39] The arguments of the Minister do identify uncertainties. However, they are not uncertainties based on whether a future event will or will not occur. They do not meet the Winter test for contingent liability.
4. Reasons of Bastarache and Abella JJ.
[40] I have had the opportunity to read the reasons of Bastarache and Abella JJ. They say that because the sale of the seismic data only occurs if there is insufficient revenue generated under ss. 2 and 3 of Schedule 1 to the note and because the generation of revenue is contingent, the sale of the seismic data under s. 7 of Schedule 1 is contingent and therefore the liability is contingent. I cannot agree with their approach. The Winter definition of contingent liability is “a liability which depends for its existence upon an event which may or may not happen” (p. 262 (emphasis added)). Whether liability under the note is to be satisfied from the generation of revenue or from the sale of the seismic data, when these events are viewed in the sequence they occur, it is clear the liability is to be repaid and thus its existence does not depend upon an event which may or may not happen. The terms of Schedule 1 to the note provide that the liability is to be satisfied one way or the other, either from the generation of revenue or the sale of the seismic data if the revenue generation is insufficient. The uncertainty identified by my colleagues is uncertainty as to the source from which the liability is to be repaid. It does not affect the existence of the liability.
[41] My colleagues also say that because McLarty is only obliged to repay 60% of the proceeds of the sale of the security that this cannot be equated to an absolute liability to pay $85,000. They say “[w]hat if the note had specified the “default” as Mr. McLarty owing 30% of the sale of the proceeds, or even 2%? Would the note still be considered an absolute liability to repay $85,000? We think not” (para. 90). With respect, I think my colleagues, like the Minister, are conflating the issue of whether the security is sufficient to repay the full value of the note and implicitly, that the seismic data was overvalued, with the issue of whether the liability is absolute or contingent. In an appropriate case, overvaluation to obtain a tax advantage may be attacked by the Minister on at least the basis that the valuation is unreasonable or that a note constitutes a sham or that the parties are not dealing at arm’s length. The Minister is not without remedies for overvaluation, but trying to characterize the liability as contingent in this case is not one of them.
[42] I agree with the Federal Court of Appeal that the liability in this case is not contingent.
B. Were the Parties Dealing at Arm’s Length?
1. Statutory Provisions
[43] It has long been established that when parties are not dealing at arm’s length, there is no assurance that the transaction “will reflect ordinary commercial dealing between parties acting in their separate interests” (Swiss Bank Corp. v. M.N.R., [1974] S.C.R. 1144, at p. 1152). The provisions of the Income Tax Act pertaining to parties not dealing at arm’s length are intended to preclude artificial transactions from conferring tax benefits on one or more of the parties. Where the parties are found not to be dealing at arm’s length, the taxpayer who has made an acquisition is deemed to have made the acquisition at fair market value regardless of whether the amount paid was in excess of fair market value. Section 69(1) (a) provides:
69. (1) Except as expressly otherwise provided in this Act,
(a) where a taxpayer has acquired anything from a person with whom the taxpayer was not dealing at arm’s length at an amount in excess of the fair market value thereof at the time the taxpayer so acquired it, the taxpayer shall be deemed to have acquired it at that fair market value;
[44] Arm’s length is not defined in the Income Tax Act . However, s. 251(1) provides:
251. (1) For the purposes of this Act,
(a) related persons shall be deemed not to deal with each other at arm’s length; and
(b) it is a question of fact whether persons not related to each other were at a particular time dealing with each other at arm’s length.
[45] The parties in this case were not related. It is therefore a question of fact whether they were dealing at arm’s length.
2. Facts Specific to the Arm’s Length Issue
[46] In the fall of 1992, McLarty received an Offering Memorandum which outlined the proposed CRC joint venture. The Offering Memorandum provided for the appointment of Compton as agent for the joint venture participants to acquire seismic data. The Offering Memorandum provided that the acquisition of the data was subject to the condition that the purchase price “will not be higher than the lowest appraised value received from three experienced, independent valuators”. The three independent appraisals were for $39,787,800, $41,930,760 and $34,405,000.
[47] On December 30, 1992, Compton acquired the seismic data, a portion of which was to be offered to the joint venture participants. On December 31, 1992, McLarty entered into a Subscription Agreement with Compton that incorporated three agreements, all dated December 31, 1992: the Subscription Agreement, the Joint Venture Agreement and the agreement to purchase the seismic data. These agreements implemented the transaction outlined in the Offering Memorandum and McLarty’s subscription was subject to the terms of the Offering Memorandum.
[48] The joint venture participants collectively acquired a 30.35% undivided interest in the data from Compton for a total consideration of $6,373,335. McLarty acquired a 1.57% undivided interest for $100,000.
3. Decision of the Trial Judge
[49] The trial judge first noted that the Minister did not originally assess on the basis that McLarty and Compton were not dealing at arm’s length. Therefore, the onus was on the Minister to prove the transactions were not at arm’s length (trial judge’s reasons, at para. 51).
[50] The trial judge found:
a. The appropriate relationship to assess was that between Compton and McLarty.
b. It was McLarty’s decision to invest.
c. There was no evidence that the principal of Compton, Ernie Sapieha, influenced the decision of McLarty to invest.
d. There was no evidence that McLarty and Compton acted in concert without separate interests.
e. There was no evidence that Compton or Sapieha imposed the purchase of the seismic data on McLarty or had the power to do so.
f. There was no collusion to inflate the price of the seismic data because McLarty had accepted the terms of the Offering Memorandum which limited the purchase price to not higher than the lowest of three independent appraisals.
[51] The trial judge concluded that in acquiring his interest in the seismic data, McLarty was dealing with Compton at arm’s length.
4. Decision of the Federal Court of Appeal
[52] The Court of Appeal was of the opinion that there were three issues to consider in deciding the arm’s length question.
a. Did