Shell Canada Ltd. v. Canada

Shell Canada Ltd. v. Canada
Collection
Supreme Court Judgments
Date
1999-10-15
Report
[1999] 3 SCR 622
Case number
26596
Judges
L'Heureux-Dubé, Claire; Gonthier, Charles Doherty; McLachlin, Beverley; Iacobucci, Frank; Major, John C.; Bastarache, Michel; Binnie, William Ian Corneil
On appeal from
Federal Court of Appeal
Subjects
Taxation
Notes
SCC Case Information: 26596
Decision Content
Shell Canada Ltd. v. Canada, [1999] 3 S.C.R. 622
Shell Canada Limited Appellant/Respondent on cross-appeal
v.
Her Majesty The Queen Respondent/Appellant on cross-appeal
and
Canadian Pacific Limited and Her Majesty The Queen Interveners
Indexed as: Shell Canada Ltd. v. Canada
File No.: 26596.
Hearing and judgment: June 14, 1999.
Reasons delivered: October 15, 1999.
Present: L’Heureux‑Dubé, Gonthier, McLachlin, Iacobucci, Major, Bastarache and Binnie JJ.
on appeal from the federal court of appeal
Income Tax – Income from business – Deductions – Interest – Taxpayer entering into debenture agreements with foreign lenders to borrow NZ dollars – NZ dollars used by taxpayer to purchase US dollars pursuant to forward exchange contract with foreign bank – Interest on debentures payable semi-annually at market rate – Whether s. 20(1)(c)(i) of Income Tax Act allows taxpayer to deduct from its income all of semi-annual interest payments made to lenders under debenture agreements – If so, whether s. 67 or former s. 245(1) of Income Tax Act applicable to reduce deduction to amount that would have been paid if US dollars had been borrowed directly – Income Tax Act, R.S.C., 1985, c. 1 (5th Supp .), ss. 20(1) (c)(i), 67 – Income Tax Act , S.C. 1970-71-72, c. 63, s. 245(1).
Income Tax – Income or capital gain – Net foreign exchange gain – Whether net foreign exchange gain taxable as income or as capital gain.
In 1988, Shell required approximately US$100 million for general corporate purposes. To get the money at the lowest possible after-tax cost, first, it entered into debenture agreements with three foreign lenders borrowing NZ$150 million at the market rate of 15.4 percent per annum. Shell was required to make 10 semi-annual interest payments of NZ$11.55 million. The principal was to be returned to the lenders in 1993. Second, Shell entered into a forward exchange contract with a foreign bank, pursuant to which it used the NZ$150 million to purchase approximately US$100 million. The forward exchange contract also allowed Shell to exchange a specified amount of US dollars for NZ$11.55 million on each day that a semi-annual payment to the lenders was due, and to exchange another specified amount of US dollars for NZ$150 million when the time came to repay the principal to the lenders. The exchange rates in the forward exchange contract were established by reference to the forward exchange rates for NZ dollars for the period of the loan.
When computing its income for tax purposes, Shell relied on s. 20(1) (c) of the Income Tax Act and deducted the interest, calculated at the rate of 15.4 percent per annum, that it had paid under the debenture agreements. For its 1993 taxation year, Shell reported a capital gain of approximately US$21 million. The Minister of National Revenue reassessed Shell for the 1992 and 1993 taxation years on the basis that it was only permitted to deduct interest at the rate it would have paid had it borrowed US dollars, i.e., 9.1 percent per annum. The claimed capital gain for the 1993 taxation year was also reassessed as being on income account. The Tax Court of Canada set aside the Minister’s reassessment. The Federal Court of Appeal allowed the Minister’s appeal but held that Shell could claim the net foreign exchange gain on capital account. Shell appealed to this Court on the interest rate issue and the Minister cross-appealed on the capital gain issue.
Held: The appeal should be allowed. The cross-appeal should be dismissed.
(1) Appeal
Shell was entitled to deduct from its income all of its semi-annual payments of interest made to the lenders under the debenture agreements during the relevant taxation years. Section 20(1) (c)(i) of the Income Tax Act allows taxpayers to deduct from their income interest payments on borrowed money that is used for the purpose of earning income from a business or property. The provision has four elements: (1) the amount must be paid in the year or be payable in the year in which it is sought to be deducted; (2) the amount must be paid pursuant to a legal obligation to pay interest on borrowed money; (3) the borrowed money must be used for the purpose of earning non-exempt income from a business or property; and (4) the amount must be reasonable, as assessed by reference to the first three requirements.
Here, the four elements are met. First, the amounts paid by Shell to the lenders were actually paid during the years in which they were sought to be deducted. Second, Shell had a legal obligation to make the semi-annual payments to the lenders under the debenture agreements. Third, there is a sufficiently direct link between the borrowed money and the current eligible use. In this case, the NZ$150 million that Shell borrowed from the lenders was directly used for the purpose of producing income from its business. 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. Fourth, under s. 20(1) (c), a taxpayer is entitled to deduct the lesser of (1) the actual amount paid or, (2) a reasonable amount in respect of “an amount paid . . . pursuant to a legal obligation to pay interest on . . . borrowed money used for the purpose of earning income from a business or property”. Here, the borrowed money that was used for the purpose of earning income was the NZ$150 million at 15.4 percent – the market rate for a loan of NZ dollars in 1988 for a five-year term. Where an interest rate is established in a market of lenders and borrowers acting at arm’s length from each other, it is generally a reasonable rate.
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. There are, however, caveats to this rule. First, 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. Second, it is well established 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.
Courts must be cautious before finding within the clear provisions of the Act an unexpressed legislative intention. Absent a specific provision to the contrary, it is not the courts’ role to prevent taxpayers from relying on the sophisticated structure of their transactions, arranged in such a way that the particular provisions of the Act are met, on the basis that it would be inequitable to those taxpayers who have not chosen to structure their transactions that way.
Where the applicable provision has its own internal reference to “reasonableness”, as does s. 20(1)(c)(i), s. 67 of the Act could not apply without distorting the plain meaning of the more specific provision. Indeed, if a deduction is “reasonable” within the meaning of s. 20(1) (c)(i), it is difficult to see how it would not also be “reasonable” within the meaning of s. 67.
Because even the broadest interpretation of the former s. 245(1) of the Act does not apply to limit Shell’s deductions, it is unnecessary in this appeal to determine conclusively the proper interpretation to be given to it. In any event, on the broad test for the former s. 245(1) developed by the Federal Court of Appeal, Shell’s decision to deduct its interest payments to the lenders at the rate of 15.4 percent per annum cannot be impugned. First, deducting the interest at that rate is not contrary to the object and spirit of s. 20(1) (c)(i). Second, the deductions were based on transactions that were in accordance with normal business practice. Third, there was a bona fide business purpose for the debenture agreements that gave rise to the deductions in issue.
(2) Cross-appeal
The US$21 million net foreign exchange gain should be taxed as a capital gain. Whether a foreign exchange gain arising from a hedging contract should be characterized as being on income or capital account depends on the characterization of the debt obligation to which the hedge relates. Shell entered into the foreign exchange contract in order to hedge with US dollars the market risk on the debenture agreements, which were denominated in NZ dollars. The gain on the debenture agreements was characterized as being earned on capital account and so therefore should the gain on the foreign exchange contract.
Cases Cited
Considered: Bronfman Trust v. The Queen, [1987] 1 S.C.R. 32; Tennant v. M.N.R., [1996] 1 S.C.R. 305; Canada v. Fording Coal Ltd., [1996] 1 F.C. 518, leave to appeal denied, [1996] 3 S.C.R. viii; Canada v. Central Supply Co. (1972) Ltd., [1997] 3 F.C. 674, leave to appeal denied, [1997] 3 S.C.R. vii; referred to: Canada Safeway Ltd. v. Minister of National Revenue, [1957] S.C.R. 717; Reference as to the Validity of Section 6 of the Farm Security Act, 1944 of Saskatchewan, [1947] S.C.R. 394, aff’d [1949] A.C. 110; Mohammad v. The Queen, 97 D.T.C. 5503; Canada v. Irving Oil Ltd., [1991] 1 C.T.C. 350; Continental Bank Leasing Corp. v. Canada, [1998] 2 S.C.R. 298; Canada v. Antosko, [1994] 2 S.C.R. 312; Friesen v. Canada, [1995] 3 S.C.R. 103; Alberta (Treasury Branches) v. M.N.R., [1996] 1 S.C.R. 963; Canderel Ltd. v. Canada, [1998] 1 S.C.R. 147; Royal Bank of Canada v. Sparrow Electric Corp., [1997] 1 S.C.R. 411; Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536; Duha Printers (Western) Ltd. v. Canada, [1998] 1 S.C.R. 795; Neuman v. M.N.R., [1998] 1 S.C.R. 770; Hickman Motors Ltd. v. Canada, [1997] 2 S.C.R. 336; Canada v. Mara Properties Ltd., [1995] 2 F.C. 433; The Queen v. Nova Corporation of Alberta, 97 D.T.C. 5229; Produits LDG Products Inc. v. The Queen, 76 D.T.C. 6344; The Queen v. Alberta and Southern Gas Co., [1978] 1 F.C. 454; Tip Top Tailors Ltd. v. Minister of National Revenue, [1957] S.C.R. 703; Alberta Gas Trunk Line Co. v. M.N.R., [1972] S.C.R. 498; Columbia Records of Canada Ltd. v. M.N.R., [1971] C.T.C. 839; Beauchamp (H.M. Inspector of Taxes) v. F. W. Woolworth plc., [1989] B.T.C. 233; Friedberg v. Canada, [1993] 4 S.C.R. 285; Ikea Ltd. v. Canada, [1998] 1 S.C.R. 196.
Statutes and Regulations Cited
Income Tax Act, R.S.C., 1985, c. 1 (5th Supp .), ss. 9(1) , (3) , 18(1) (b), 20(1) (c)(i), 67 .
Income Tax Act , S.C. 1970-71-72, c. 63, s. 245(1) [rep. & sub. 1988, c. 55, s. 185].
Authors Cited
Broadhurst, David G. “Income Tax Treatment of Foreign Exchange Forward Contracts, Swaps, and Other Hedging Transactions”, in Report of Proceedings of the Forty-First Tax Conference. Toronto: The Foundation, 1990.
Hogg, Peter W., and Joanne E. Magee. Principles of Canadian Income Tax Law, 2nd ed. Scarborough: Carswell, 1997.
Ruby, Stephen S. “Recent Financing Techniques”, in Report of Proceedings of the Forty-First Tax Conference. Toronto: The Canadian Tax Foundation, 1990.
APPEAL and CROSS-APPEAL from a judgment of the Federal Court of Appeal, [1998] 3 F.C. 64, [1998] 2 C.T.C. 207, 157 D.L.R. (4th) 655, 223 N.R. 122, 98 D.T.C. 6177, [1998] F.C.J. No. 194 (QL), allowing in part the Minister’s appeal from a decision of the Tax Court of Canada, [1997] 3 C.T.C. 2238, 97 D.T.C. 395, [1997] T.C.J. No. 285 (QL), which allowed the taxpayer’s appeal from the Minister’s reassessment. Appeal allowed and cross-appeal dismissed.
Alnasir Meghji, Ronald B. Sirkis, Gerald A. Grenon and Edward Rowe, for the appellant/respondent on cross-appeal.
S. Patricia Lee and Harry Erlichman, for the respondent/appellant on cross-appeal/intervener.
Michael E. Barrack and Gabrielle M. R. Richards, for the intervener Canadian Pacific Limited.
The judgment of the Court was delivered by
1 McLachlin J. – This appeal by Shell Canada Limited (“Shell”) and the cross-appeal by the Minister of National Revenue (the “Minister”) require the Court to consider the proper income tax treatment of a sophisticated corporate financing arrangement. At the conclusion of the hearing, the Court allowed Shell’s appeal and dismissed the Minister’s cross-appeal, with reasons to follow for both decisions. These are those reasons.
I. Facts
2 In 1988, Shell required approximately $100 million in United States currency (“US$”) for general corporate purposes. To get the money it required at the lowest possible after-tax cost, Shell embarked upon a complex financing scheme that proceeded in two stages. First, Shell entered into debenture purchase agreements (the “Debenture Agreements”) with three foreign lenders, pursuant to which it borrowed approximately $150 million in New Zealand currency (“NZ$”) at the market rate of 15.4 percent per annum. Shell was required to make payments of NZ$11.55 million to the foreign lenders on November 10 and May 10 of each year until 1993. The principal of NZ$150 million was to be returned to the foreign lenders on May 10, 1993.
3 Second, Shell entered into a forward exchange contract (the “Forward Exchange Contract”) with Sumitomo Bank Ltd. (“Sumitomo”), pursuant to which it used the NZ$150 million it had borrowed from the foreign lenders to purchase approximately US$100 million. That US$100 million was then used in Shell’s business. The Forward Exchange Contract between Shell and Sumitomo also allowed Shell to, (1) exchange a specified amount of US$ for NZ$11.55 million on each day that a semi-annual payment to the foreign lenders was due, and (2) to exchange another specified amount of US$ for NZ$150 million when the time came to repay the principal to the foreign lenders.
4 The exchange rates in the Forward Exchange Contract were established by reference to the forward (or “future”) exchange rates for NZ$ for the period of the loan, i.e., how much it would cost to purchase NZ$ when Shell required it in the future. Because of the declining value of the NZ$ at the time, the forward value (in US$) of the NZ$150 million Shell was required to repay the foreign lenders in 1993 was expected to be less than the current (or “spot”) value (in US$) of the same NZ$150 million when Shell borrowed it in 1988. Shell accordingly expected to realize a foreign exchange gain when it closed out the Forward Exchange Contract and repaid the principal to the foreign lenders using the devalued NZ$.
5 Shell also knew that the difference between the spot exchange rate and the forward exchange rate as between two currencies precisely reflects the difference between their current interest rates over the period of the loan. The amount of the foreign exchange gain Shell expected to earn would therefore reflect the difference between the interest rates for the two currencies for the period of the Debenture Agreements. Accordingly, by agreeing to buy NZ$ in the future at the lower forward exchange rate, Shell not only was able to “hedge” its exposure to the market fluctuation of the NZ$, but was also able to effectively bring the rate of interest it was paying for the NZ$ down to approximately the rate of interest it would have had to pay for US$.
6 The Debenture Agreements and the Forward Exchange Contract all closed on May 10, 1988. Shell was only obligated to abide by the former if the latter also closed. While it seems that the foreign lenders received from Sumitomo the NZ$ that they paid to Shell, which in turn sold the same NZ$ back to Sumitomo in exchange for US$, Shell was not aware of the source of the foreign lenders’ funds until after Shell had committed itself to entering the Debenture Agreements. All of the contracts closed properly, and all the funds changed hands as planned.
7 The trial judge made a number of specific findings about the Debenture Agreements and the Forward Exchange Contract. He found, inter alia, that Shell’s decision to enter into these arrangements was based on its expectation that it would be able to deduct from its income the interest paid on the Debenture Agreements and that the foreign exchange gain would be taxed on capital account. Taxing the foreign exchange gain on capital account would be an advantage for Shell because, (1) only 75 percent of the gain would be taxable, rather than 100 percent as would be the case were it included on income account, and (2) the gain could be used to offset some of Shell’s existing capital losses. The trial judge further found that Shell would not have entered into the Debenture Agreements in the absence of the Forward Exchange Contract, that none of the transactions was a sham, and that if Shell had simply borrowed US$ at a market rate of interest, it would have paid 9.1 percent per annum instead of the 15.4 percent per annum it had paid for the NZ$.
8 When computing its income for tax purposes for the years 1988 to 1993 inclusive, Shell relied on s. 20(1) (c) of the Income Tax Act, R.S.C., 1985, c. 1 (5th Supp .) (the “Act ”), and deducted the interest, calculated at the rate of 15.4 percent per annum, that it had paid to the foreign lenders under the Debenture Agreements. For its 1993 taxation year, the year in which the Forward Exchange Contract was closed out and the principal was repaid to the foreign lenders under the Debenture Agreements, Shell reported a capital gain of approximately US$21 million.
9 The Minister objected and issued formal reassessments for the 1992 and 1993 taxation years. By these reassessments, Shell was only permitted to deduct interest at the rate it would have paid had it borrowed US$, i.e., 9.1 percent per annum over a five-year term, because, according to the Minister, it was only the US$ -- not the NZ$ -- that were directly used in its business. The claimed capital gain for the 1993 taxation year was also reassessed as being on income account.
10 The Tax Court of Canada allowed Shell’s appeal from the Minister’s reassessment. The Minister was then partly successful in his appeal to the Federal Court of Appeal, which held that Shell could only claim the limited interest rate deduction suggested by the Minister but could however claim the net foreign exchange gain on capital account. Shell now appeals to this Court the Federal Court of Appeal’s decision on the interest rate issue. The Minister cross-appeals the Federal Court of Appeal’s disposition of the capital gain issue.
11 The interveners are parties in another appeal before this Court: Canadian Pacific Ltd. v. The Queen, S.C.C., File No. 27163*. Because of the similarities between that case and the one now before this Court, these parties were granted leave to intervene in this appeal.
II. Statutory Provisions
12 Income Tax Act, R.S.C., 1985, c. 1 (5th Supp .)
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.
. . .
(3) In this Act , “income from a property” does not include any capital gain from the disposition of that property and “loss from a property” does not include any capital loss from the disposition of that 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;
67. In computing income, no deduction shall be made in respect of an outlay or expense in respect of which any amount is otherwise deductible under this Act , except to the extent that the outlay or expense was reasonable in the circumstances.
Income Tax Act , S.C. 1970-71-72, c. 63
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.
III. Judgments Below
A. Tax Court of Canada, [1997] 3 C.T.C. 2238
13 Christie A.C.J.T.C. began by observing that it is open to a taxpayer to structure its affairs to secure tax benefits. Tax considerations are part of the commercial and economic reality within which business decisions are made. He also rejected (at para. 20) what he called the “foundation stone” of the Minister’s argument, namely that the effect of Shell’s arrangements was that the Debenture Agreements and the Forward Exchange Contract were merged into one for tax purposes. In the absence of clear judicial or statutory authority, Christie A.C.J.T.C. held that it was not open to him to recharacterize a taxpayer’s distinct legal relationships.
14 With respect to the deductibility of Shell’s interest payments to the foreign lenders, Christie A.C.J.T.C. held that the rate of 15.4 percent per annum was a market rate and, as such, was “reasonable” within the meaning of s. 20(1) (c)(i) of the Act . The fact that the NZ$ were immediately exchanged for US$ before being applied to general corporate purposes did not deprive the NZ$ of its character as borrowed money used for the purpose of earning income from a business. Shell was therefore entitled to deduct the interest at the rate of 15.4 percent per annum.
15 The Minister also relied on s. 67 and former s. 245(1) of the Act . Christie A.C.J.T.C. rejected the argument that s. 67 could operate to reduce the permissible rate of deductible interest when that rate had already been found to be reasonable within the meaning of s. 20(1) (c)(i). For the same reason, neither did he see any scope for the application of former s. 245(1) , which addressed deductions that “unduly or artificially” reduced a taxpayer’s income. Even if s. 245(1) could operate to reduce a deduction otherwise permitted by the Act , he held that it did not apply here. Shell’s transactions were not contrary to the object and spirit of s. 20(1) (c)(i) and the evidence showed that they were in accordance with normal business practice.
16 With respect to the gain realized in 1993, Christie A.C.J.T.C. concluded that, generally, an agreement to borrow a specified amount of funds for a fixed period of five years for the purpose of earning income is to be regarded as a capital transaction. There was no reason to hold otherwise in this case. If there were two gains – one on the Debenture Agreements and one on the Forward Exchange Contract – he held that they should be treated similarly. Christie A.C.J.T.C. allowed Shell’s appeal from the Minister’s reassessment.
B. Federal Court of Appeal, [1998] 3 F.C. 64
17 The Minister appealed to the Federal Court of Appeal. After reviewing the origins of s. 20(1) (c)(i) and its predecessor provisions, Linden J.A. concluded that Parliament intended “to restrict the deduction [of interest] to those amounts that were reasonable and which reflected the economic realities of the situation” (para. 31). Here, that amount was 9.1 percent per annum, the rate at which US$ were directly available to Shell.
18 Linden J.A. held that there were four elements of s. 20(1) (c)(i). To be deductible, (1) the amount must be paid or payable in the year in which it is deducted; (2) it must be paid pursuant to a legal obligation to pay interest on borrowed money; (3) the borrowed money must be used for the purpose of earning income from a business or property; and (4) the amount must be calculated at a reasonable rate. Shell’s attempted deduction satisfied only the first criterion.
19 Linden J.A. concluded that the second condition had not been met. Considering that he was not “constrained by contract theory” (para. 59) and that the important consideration was “not what the parties agree to, nor what their intent is” (para. 59), he held that the Debenture Agreements and the Forward Exchange Contract had to be considered together to determine whether the amounts Shell sought to deduct were actually “interest”. In his view, the real “interest” amounts could only be identified after reducing the putative interest payments by an amount equal to the foreign exchange gain created by the discounted forward rate on the NZ$, amortized over the term of the loan. On this approach, he concluded that Shell’s deductions were not entirely interest: that portion exceeding 9.1 percent per annum must have been a repayment of principal.
20 Neither had the third condition been met, held Linden J.A: “[l]ooking realistically at the substance of the situation, there was no use and purpose other than the avoidance of taxation for borrowing NZ$” (para. 60). This, he concluded, was not an eligible use. Because only the US$ were used to earn eligible income, s. 20(1) (c)(i) permitted only the deduction of interest calculated at the rate of 9.1 percent per annum.
21 Shell’s attempted deduction also failed to satisfy the fourth condition. While it was reasonable for the foreign lenders to charge 15.4 percent per annum on the loan of the NZ$, Linden J.A. held that it was not reasonable for Shell to pay that rate. The only money used for an eligible purpose was the US$, held Linden J.A., and the reasonableness of the deduction must be assessed on that basis: “Shell should be in the same position as a taxpayer who borrowed US$ directly. That interest rate was then 9.1%” (para. 63). In Linden J.A.’s view, this fourth criterion was a type of “anti-avoidance” tool that should be used to prevent a taxpayer from artificially reducing its tax payable. In his opinion, that was what had happened here.
22 Given his conclusion with respect to s. 20(1) (c)(i), Linden J.A. did not have to address s. 67 or s. 245(1) .
23 Turning to whether the gain realized in 1993 was earned on income or capital account, Linden J.A. concluded that there were two gains. One gain was earned on the Forward Exchange Contract because the forward exchange rate set by the Forward Exchange Contract was lower than the spot rate of exchange for converting US$ into NZ$ in 1993. The second gain arose on the Debenture Agreements because the 1993 value of the NZ$150 million that Shell repaid to the foreign lenders was less than the value of the NZ$ it had borrowed in 1988. Linden J.A. held that Christie A.C.J.T.C. correctly concluded that the character of a foreign exchange gain is determined by the nature of the underlying transaction. Here, the underlying transactions – the Debenture Agreements and the Forward Exchange Contract – were capital in nature, and so therefore must be the gains. He noted that the Minister had indicated that adjustments would be made to the amount of the taxable foreign exchange gain to reflect his success on the interest rate issue.
24 Stone J.A. wrote concurring reasons, addressing only the Minister’s alternative argument that s. 245(1) applied to Shell’s transactions in the event that s. 20(1) (c)(i) did not reduce the effective rate of interest to 9.1 percent per annum. He rejected this submission, holding that the transactions were not contrary to the object and spirit of s. 20(1) (c)(i), that they were in accordance with normal business practice, and that they had a bona fide business purpose, namely the acquisition of capital for a legitimate business use.
IV. Issues
25 There are two main issues on Shell’s appeal. First, does s. 20(1) (c)(i) of the Act allow Shell to deduct from its income all of the semi-annual interest payments it made to the foreign lenders under the Debenture Agreements? Second, if so, does either s. 67 or the former s. 245(1) of the Act apply to reduce the deduction to the amount that would have been paid if US$ had been borrowed directly?
26 The issue on the Minister’s cross-appeal is whether the approximately US$21 million foreign exchange net gain that Shell earned should be taxed as part of Shell’s income, or taxed as a capital gain.
V. Analysis
A. Does Section 20(1)(c)(i) Allow Shell to Deduct from Its Income All of the Payments It Made to the Foreign Lenders Under the Debenture Agreements?
1. How Should Section 20(1)(c)(i) Be Applied to this Case?
27 I propose to first outline how s. 20(1)(c)(i) seems to apply to this case, before turning to consider the objections made by the Minister and accepted by the Federal Court of Appeal.
28 Section 20(1)(c)(i) allows taxpayers to deduct from their income interest payments on borrowed money that is used for the purpose of earning income from a business or property. It is an exception to s. 9 and s. 18(1)(b), which would otherwise prohibit the deduction of amounts expended on account of capital, i.e., interest on borrowed funds used to produce income: Canada Safeway Ltd. v. Minister of National Revenue, [1957] S.C.R. 717, at pp. 722-23, per Kerwin C.J., and at p. 727, per Rand J.; Bronfman Trust v. The Queen, [1987] 1 S.C.R. 32, at p. 45, per Dickson C.J. The provision has four elements: (1) the amount must be paid in the year or be payable in the year in which it is sought to be deducted; (2) the amount must be paid pursuant to a legal obligation to pay interest on borrowed money; (3) the borrowed money must be used for the purpose of earning non-exempt income from a business or property; and (4) the amount must be reasonable, as assessed by reference to the first three requirements.
29 The first element is clearly met. No one disputes that the amounts paid by Shell to the foreign lenders were actually paid during the years in which they were sought to be deducted.
30 The second element is also met. Shell had a legal obligation to make the semi-annual payments to the foreign lenders under the Debenture Agreements. Those semi-annual payments constituted “interest”, or “the return or consideration or compensation for the use or retention by one person of a sum of money, belonging to, in a colloquial sense, or owed to, another”: Reference as to the Validity of Section 6 of the Farm Security Act, 1944 of Saskatchewan, [1947] S.C.R. 394, aff’d [1949] A.C. 110 (P.C.). As between Shell and the foreign lenders, there is no indication that the semi-annual payments were anything but consideration for the use, for five years, of the NZ$150 million that Shell had borrowed. It was not a synthesized US$ loan from the foreign lenders to Shell: Shell actually received the NZ$150 million from the foreign lenders under the Debenture Agreements and paid real interest in consideration for its use.
31 The third element -- that the borrowed money is used for the purpose of earning non-exempt income from a business or property -- has likewise been met. This element focuses not on the purpose of the borrowing per se, but rather on the taxpayer’s purpose in using the borrowed money. As Dickson C.J. stated in Bronfman Trust, supra, at p. 46, “the focus of the inquiry must be centered on the use to which the taxpayer put the borrowed funds”. Dickson C.J. further specified that it is the current use of the borrowed money that is relevant and that the provision generally “requires tracing the use of borrowed funds to a specific eligible use”: Bronfman Trust, supra, at p. 53. 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., [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.
32 Here, Shell borrowed NZ$150 million from the foreign lenders and immediately exchanged it for approximately US$100 million before applying it to its business. This exchange did not alter the basic character of the funds as “borrowed money”. Money is fungible. The US$100 million was simply the NZ$150 million transformed into a different currency which, although it changed its legal form and its relative value, did not change its substance. It remained money. The value it represented simply changed from being denominated in New Zealand currency to being denominated in United States currency. Viewed thus, it is apparent that all of the NZ$150 million that Shell borrowed from the foreign lenders was borrowed money currently and directly used for the purpose of producing income from Shell’s business. The direct link between the borrowed money and the activity calculated to produce income can hardly be compared to the indirect use at issue in Bronfman Trust, supra.
33 The mere fact that an exchange had to occur before usable money was produced is not particularly significant. Except where the borrower is a money trader, borrowed money can rarely itself produce income. It must always be exchanged for something, whether it be machinery or goods, which then produces income. The necessity of such an exchange does not mean that the eventual production of income is an indirect use of the borrowed money. If a direct link can be drawn between the borrowed money and an eligible use, the third criterion is satisfied. That is clearly the case here.
34 The fourth element – that the amount sought to be deducted must be the actual amount paid or “a reasonable amount in respect thereof” – has not previously been the subject of comment by this Court. It is clear, however, from the structure of s. 20(1)(c), that the phrase refers to the entirety of s. 20(1)(c)(i). Therefore, the taxpayer is entitled to deduct the lesser of, (1) the actual amount paid or, (2) a reasonable amount in respect of “an amount paid . . . pursuant to a legal obligation to pay interest on . . . borrowed money used for the purpose of earning income from a business or property”. Here, the borrowed money that was used for the purpose of earning income was the NZ$150 million. At trial, Christie A.C.J.T.C. found that the market rate for a loan of NZ$ in 1988 for the five-year term specified in the Debenture Agreements was 15.4 percent per annum. That is the rate Shell paid. Where an interest rate is established in a market of lenders and borrowers acting at arm’s length from each other, it is generally a reasonable rate: Mohammad v. The Queen, 97 D.T.C. 5503 (F.C.A.), at p. 5509, per Robertson J.A.; Canada v. Irving Oil Ltd., [1991] 1 C.T.C. 350 (F.C.A.), at p. 359, per Mahoney J.A. The fourth criterion is accordingly satisfied.
35 On this analysis, Shell was entitled to deduct from its income all of its semi-annual payments of interest to the foreign lenders during the relevant taxation years.
2. The Minister’s Objections
36 The Minister objects to this application of s. 20(1)(c)(i). He makes two principal arguments. First, he submits that because only the US$ were used for the purpose of earning income from a business, Shell is only entitled to deduct as “interest” those amounts relating to the US$. This amount, he argues, must be calculated by reference to the rate of 9.1 percent per annum, the rate applicable to a borrowing of US$ in 1988. Second, the Minister argues that the phrase “a reasonable amount in respect thereof” in s. 20(1)(c)(i) must be interpreted as referring to a reasonable amount to pay for a loan of the US$ which were actually used to produce income. That, he again submits, must be calculated at the rate of 9.1 percent per annum. The Minister also makes a subsidiary argument that the borrowed funds for which interest was paid at a rate exceeding 9.1 percent per annum were actually being used to produce a capital gain, not eligible income from a business or property as required by s. 20(1)(c)(i). These arguments found favour with the Federal Court of Appeal. With respect, however, they cannot prevail when examined in light of the approach this Court has consistently taken when interpreting the Act in general and s. 20(1) (c)(i) in particular.
37 These arguments rest on the view that only the US$ were used to produce income from a business or property. As discussed above, that is incorrect. The fact that the NZ$ can be directly traced to an income-producing use in accordance both with the text of s. 20(1)(c)(i) and with this Court’s decisions in Bronfman Trust, supra, and Tennant, supra, deprives these arguments of any foundation.
38 Furthermore, these submissions arise from a fundamental misapprehension of the scope of s. 20(1)(c)(i) and the principles against which it should be interpreted. Both the Minister and the Federal Court of Appeal seem to suggest that s. 20(1)(c)(i) invites a wide examination of what Linden J.A. referred to (at para. 44) as the “economic realities” of a taxpayer’s situation. Underlying this argument appears to be the view that taxpayers are somehow disentitled from relying on s. 20(1)(c)(i) if the structure of the transaction was determined by a desire to minimize the amount of tax payable.
39 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, [1998] 2 S.C.R. 298, at para. 21, per Bastarache J.
40 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, [1994] 2 S.C.R. 312, at pp. 326-27 and 330, per Iacobucci J.; Friesen v. Canada, [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.
41 It is my respectful view that by paying insufficient attention to these very important principles, the Minister and the Federal Court of Appeal fell into error. First, the Federal Court of Appeal effectively recharacterized for tax purposes Shell’s legal relationship with the foreign lenders. Indeed, Linden J.A. held that, when the Forward Exchange Contract between Shell and Sumitomo was considered alongs