CIT Financial Ltd. v. The Queen

CIT Financial Ltd. v. The Queen
Court (s) Database
Tax Court of Canada Judgments
Date
2003-09-05
Neutral citation
2003 TCC 544
File numbers
1999-3593(IT)G
Judges and Taxing Officers
Donald G.H. Bowman
Subjects
Income Tax Act
Decision Content
Citation: 2003TCC544
Date: 20030905
Docket: 1999-3593(IT)G
BETWEEN:
CIT FINANCIAL LTD.,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
REASONS FOR JUDGMENT
BOWMAN, A.C.J.
A. Introduction
[1] This appeal is from an assessment for the 1993 taxation year of Commcorp Financial Services Inc. ("Commcorp") one of a number of companies that amalgamated to form the appellant, which was formerly called Newcourt Financial Ltd.
[2] Originally, there were several issues but the parties have settled all but two. After the remaining issues have been dealt with by the Court, counsel have agreed to prepare a draft judgment in which all of the issues are disposed of.
[3] The remaining issues have to do with capital cost allowance ("CCA") on software acquired by Commcorp in 1993. The Minister of National Revenue characterized the series of transactions and each transaction within the series whereby Commcorp acquired the software and then leased it back ultimately to the person who had developed it and used it in its business as an avoidance transaction within the meaning of the General Anti-Avoidance Rule ("GAAR") and determined the tax consequences to Commcorp to be that it was not entitled to claim any CCA on the software.
[4] The alternative position is that Commcorp acquired the software from a person with whom it was not dealing at arm's length and the cost to it should be reduced to the fair market value ("fmv"), which the respondent says was not greater than $13,100,000.
[5] The appellant concedes that Commcorp acquired the software from a person with whom it was not dealing at arm's length, but contends that the value at the date of the acquisition was $33,091,255.
[6] The Crown has abandoned the arguments contained in subparagraphs 13(a)(i), (ii) and (iii), that the software was not acquired by Commcorp, that if acquired it was not acquired for the purpose of gaining or producing income or that the transaction or documents were a sham.
[7] This leaves then the question of the application of GAAR and the question of the fmv of the software as well as the question of reasonableness under section 67.
B. The transactions - April 1, 1993
[8] The transactions that took place in April, 1993 are described in a Partial Statement of Agreed Facts ("PSAF"), to which are attached the relevant documents. Attached to the PSAF are two charts, Exhibits A and B, in which the legal relationships and flow of funds are set out. These two charts are attached to these reasons.
[9] The series of transactions can be summarized briefly.
[10] BHP New Zealand Steel Limited (BHP) is a steel manufacturing corporation resident in New Zealand. It owned computer applications software (the "software") that it used in operating its production function at its integrated steel-making facility at Glenbrook, New Zealand and stored data in relation to the financial management of the operation.
[11] Commcorp received an appraisal of the software from MACC and Partners Australia Limited at NZ $50,000,000. The Canadian dollar equivalent was $33,091,255. For convenience I shall from time to time in these reasons call this figure $33,000,000.
[12] BHP sold the software to Macquarie Leasing (NZ) Limited ("MLL") a subsidiary of Macquarie Bank Limited ("MBL"), an Australian Bank, for Cdn.$33,091,255 for which a promissory note was given.
[13] MLL sold the software to 1004583 Ontario Ltd. ("1004583") an Ontario company incorporated for that purpose by Commcorp's lawyers for $33,091,255 for which a promissory note was given.
[14] 1004583 leased and licensed the software to Eagle Financial and Leasing Services Limited ("Eagle"), a Cayman company and a subsidiary of Barclays Bank PLC ("Barclays"), a UK bank.
[15] The lease was for a term of 11 years expiring April 5, 2004. The lease included purchase options exercisable on April 5, 2002 and April 5, 2004 at an amount equal to the present value, calculated in 2003, of the remaining income stream.
[16] Commcorp borrowed $27,770,896.80 from Barclays to be secured by an assignment of specific amounts of rent owing under the lease to Eagle and a portion of the amounts payable upon termination of the lease which corresponded to the outstanding balance of the loan at the relevant time. Recourse under the loan was limited to the assigned payments.
[17] Eagle and MLL entered into a sublease and license agreement whereby Eagle subleased and licensed the software to MLL on substantially the same terms as the software had been leased and licensed by 1004583 to Eagle. One difference was that MLL was obliged on closing to prepay to Eagle the total rent payable under the sublease and the first option price.
[18] MLL and BHP entered into a sub-sub-lease and license agreement under which MLL sub-subleased and licensed the software to BHP on substantially the same terms as the lease and sublease, except that MLL was obliged at the request of BHP to accept prepayment of $31,933,061 in satisfaction of BHP's obligation under the lease.
[19] 1004583 entered into an agreement with Commcorp to sell the software to Commcorp on April 5, 1994 for $33,091,255.
[20] 1004583, Commcorp, Eagle, MLL and BHP and Whitaker Nominees Limited, a New Zealand corporation ("Whitaker") entered into an escrow agreement under which BHP was to deliver to Whitaker a copy of the source code, object code and software documentation for the software, a copy of the software and the original valuation. The deposit of this material with Whitaker, as escrow agent, was acknowledged to be delivery of the software under the three software sale and assignment agreements. (i.e. BHP to MLL, MLL to 1004583 and 1004583 to Commcorp)
[21] Commcorp, Barclays and Eagle entered into the Eagle Support agreement under which Eagle agreed to pay to Barclays $3,996,708. Barclays also agreed that wherever a "specified payment" became payable under the lease Barclays would pay or cause Eagle to pay out of the proceeds of the bond which Barclays agreed would be purchased with the $3,996,709. The "specified payments" were the scheduled rents and other amounts (including termination amounts) payable under the lease except to the extent that they were not assigned as security under the loan.
[22] Barclays wrote to Commcorp agreeing that it would ensure that Eagle would meet its obligations under the agreements to which it was a party.
[23] MLL, Eagle, Commcorp and 1004583 entered into a coordination agreement under which the obligations under the lease were divided into "Recourse covenants" which MLL agreed to perform and "Limited recourse covenants" which Eagle agreed to perform. Eagle gave MLL a power of attorney to exercise all of the rights of Eagle under the lease. As part of that agreement Commcorp executed a Non-Disturbance undertaking under which Commcorp agreed to be bound by the terms of the sub-sublease even if there was a default by Eagle or MLL under the lease or the sublease so long as BHP was not in default under the sub-sub lease.
[24] MBL guaranteed the obligations of MLL under various agreements.
[25] The moneys flowed as contemplated by the various agreements all from and to accounts of the parties at Barclays and the transactions closed on April 5, 1993. Paragraphs 11 and 12 of the PSAF summarize what happened that day:
11. On April 5, 1993 (see attached Exhibit A):
(a) BHP assigned and transferred the Software to MLL pursuant to the BHP NZS Software Sale and Assignment Agreement and MLL executed a Promissory Note in favour of BHP in the amount of $33,091,255.00 in satisfaction of the purchase price payable by MLL for the Software,
(b) MLL assigned and transferred the Software to 1004583 pursuant to the MLL Software Sale and Assignment Agreement and 1004583 executed a Promissory Note in favour of MLL in the amount of $33,091,255.00 in satisfaction of the purchase price of the Software,
(c) 100483 (sic) leased and licensed the Software to Eagle pursuant to the Lease,
(d) 1004583 assigned and transferred the Software to Commcorp pursuant to the Commcorp Software Sale and Assignment Agreement,
(e) Eagle subleased and sublicenced the Software to MLL pursuant to the Sub-Lease and Licence Agreement.
The documents included in Tabs 26-50 were also executed in connection with the above.
12. On April 5, 1993, the flow of funds was as follows:
(a) Barclays advanced $27,770,896.80 to Commcorp pursuant to the Loan;
(b) Barclays transferred the amounts referred to in the Directions, in accordance with the Directions, namely:
(i) $33,091,255 from Commcorp to 1004583;
(ii) $1,100,000 from Commcorp to MLL;
(iii) $33,091,255 from 1004583 to MLL; and
(iv) $33,091,255 from MLL to BHP;
(c) BHP paid the amount of $31,933,061 to MLL, as prepayment of the rents and purchase option under the Sub-Sub Lease and Licence Agreement;
(d) MLL paid the amount of $31,767,604 to Eagle, as a prepayment of the rents and purchase option under the Sub Lease and Licence Agreement;
(e) Eagle paid Barclays the amount of $3,996,708, in accordance with the Eagle Support Agreement;
(f) Barclays purchased the Bond for $3,996,709 in accordance with the Eagle Support Agreement, which Bond matured on March 15, 2002 for the amount of $8.13 million;
(g) The amount of $27,770,897 ($31,767,604-$3,996,708) remained within Eagle and provided funds to make the lease payments to secure and discharge the Loan.
Attached as Exhibit B is a diagram of the cash payments that were made on April 5, 1993. The amount of $1,100,000 referred to above was paid by Commcorp to MLL as fees in connection with the transaction.
[26] I need not summarize the other formal steps taken in connection with the transactions including legal opinions. These matters were fully and competently dealt with by major law firms throughout the world. The transactions and the documents that underlay them represent genuine, legally binding and enforceable obligations. They were what they purported to be.
[27] A few of the other facts as set out in the PSAF warrant being reproduced because they were considered significant by one or other of the parties and were referred to in argument:
18. The purchase price of the Software was funded by Commcorp using the $27,770,897 to be borrowed from Barclays and $6,420,358 from internal sources. This amount includes $1,100,000 which Commcorp paid to MLL as fees in respect of the transaction. Eagle paid $3.996M to Barclay. The balance of the prepayment rested with Eagle.
19. Before entering into the deal, Commcorp knew that BHP would pay an amount to MLL and MLL would pay an amount to Eagle which was sufficient to cover the obligations of Commcorp to Barclays over the life of the loan.
20. There was no indication to Commcorp that either BHP or Macquarie needed financing. This was not a deal whereby BHP or Macquarie obtained financing from Commcorp.
21. The net cash flow to Commcorp over the term of the deal regardless of whether the first purchase option is exercised is $1,711,907 (as set out Schedules I and II at Tab 72). The payments under the Lease and the principal interest payments required under the Loan are set out in Schedules at Tab 72. This schedule also includes details of the tax deductions anticipated in respect of CCA and interest and the income inclusions for tax purposes.
22. In computing its income for the 1993 taxation year (ending December 31, 1993), Commcorp included the amount of $34,191,255 in its cost of depreciable property in Class 12 of Schedule II to the Income Tax Regulations and deducted the amount of $17,313,740 as capital cost allowance under paragraph 20(1)(a) of the Income Tax Act in computing its income for that year, which amount was disallowed as a deduction by the Minister of National Revenue in reassessing the Appellant.
23. The arrangement in issue in this case was described to the Board of Directors of Commcorp (Tab 73) as a "tax predicated computer software lease that will provide Commcorp with $15MM of tax shelter in 1993 and an additional $15MM in 1994".
24. It was understood by Commcorp before entering into the deal that Eagle would sub-lease and licence the software to MLL and MLL would sub-sub-lease and licence the software to BHP. It was also understood that BHP and Macquarie would prepay their obligations under the Sub-Sub-Lease and Licence Agreement and the Sub-Lease and Licence Agreement, respectively.
25. The Appellant entered into two other deals in the following year based on the same model, involving prepayments to the leasee which was a subsidiary of the lending bank. They are referred to in Minutes of the Board of Directors Meeting of September 21, 1994 (Tab 74) as "tax advantaged software leases booked by the Corporation".
26. Commcorp's primary purpose in entering into the arrangement in issue in this case was to obtain the capital cost allowance arising from the acquisition of the Software in that the capital cost allowance was deductible in the first two years and the rents were receivable over the term of the lease.
[28] I am attaching as Exhibits I and II, the Schedules at tab 72 of the PSAF because they illustrate the real economics of the transaction. Obviously the predominant economic motivation from Commcorp's standpoint lay in the tax write off. This is not disputed. Presumably there were tax advantages in New Zealand to BHP, but I do not know exactly what they were. They are not germane to this case. The schedules however demonstrate something else - the essential circularity of the transaction. $33,000,000 was inserted at one end and it ended up back where it started. The only thing that did not move was the software. It stayed where it started - with BHP. No one - Commcorp, the bank, Eagle, BHP or anyone else in the chain - bore the slightest risk. The $33,000,00 was based on a valuation by MCC which had been selected by MBL who had an interest in seeing the deal go through because of the $1,100,000 commission that MLL was to receive. The $33,000,000 valuation bore little relation to the actual cost of developing the software which was more like $11,000,000.
[29] The simple fact is any number would have worked because the money all came back to the starting point. I shall deal with this point more fully when I discuss the fmv of the software.
[30] The third reason that the schedules are important is that they illustrate the difficulty of determining the tax consequences to deny the tax benefit "as is reasonable in the circumstances". Here the Minister has decided that this is an avoidance transaction not saved by subsection 245(4). The tax benefit is the deduction of CCA on the software. Therefore, so the reasoning goes, the deduction of the CCA should be denied but all of the other consequences over the term of the transaction from 1995 to 2004 are left untouched. Admittedly, the GAAR is something of a blunt instrument, but while it may not be a scalpel neither is it a sledgehammer.
[31] The large income and deduction anticipated over the years from 1995 to 2004 are undoubtedly predicated on a cost of $33,000,000 with its consequent tax write off. The GAAR seems to have been enacted to enable the Minister to combat overly aggressive tax avoidance schemes whose fiscal purposes far overshadowed their commercial purposes. It should not be used as an instrument to punish people for engaging in tax avoidance schemes that the Minister does not like by taking away the fiscally beneficial aspect of an avoidance transaction but leaving intact the detrimental aspects.
[32] I turn first to the question of the fmv of the software. Two valuations were submitted in evidence by the appellant. The first valuation was prepared by Mr. Geoffrey H. Cooper (the "MACC valuation") before the lease was entered into. The second valuation was made by Mr. Peter Hatges of KPMG. The Crown did not have an opportunity of examining the software before trial because it was not available. When it became available I adjourned the trial to permit the Crown's experts to examine it, but apparently the state it was in after 10 years, with all of the changes that continued use over that period entailed, made any meaningful determination of value as of April 1993 impossible. The Crown therefore relied on reports prepared by Mr. Howard E. Johnson of Campbell Valuation Partners Limited in which he comments on the appellant's expert reports.
[33] Before discussing the reports, let us look at just what we are trying to do here. Commcorp bought the software in a non-arm's length transaction and therefore the price under section 69 is deemed to be the fmv. The primary purpose of the purchase was to obtain a tax write off. Therefore one would not expect a party such as Commcorp or anyone else in the chain such as MLL, 1004583 or Eagle or, indeed, BHP, to be concerned about striking a deal that bore any relationship to its inherent commerciality because there was no commercial risk involved to anyone. We are not dealing with a parcel of land or shares in a company. The property to be valued is a unique, special purpose software package developed by BHP for its own purposes in running its steel mill in New Zealand. Its true value to BHP in the conduct of its business is unknown. It could vary within a range of indeterminate magnitude depending on the criteria used. The conventional definition of fmv is too well known to require repetition but it involves postulating a hypothetical vendor and purchaser who are at arm's length, knowledgeable and canny and who would like to make a deal but are not desperate to do so and deciding what sort of a bargain these hypothetical negotiators would strike. As Viscount Simon said in Gold Court Selection Trust Limited v. Humphrey (Inspector of Taxes), [1948] A.C. 459 at 473.
... If the asset is difficult to value but is none the less of a money value, the best valuation possible must be made. Valuation is an art, not an exact science. Mathematical certainty is not demanded, nor indeed is it possible. It is for the commissioners to express in the money value attributed by them to the asset their estimate, and this is a conclusion of fact to be drawn from the evidence before them.
[34] The difficulty with attempting to determine the fmv of the software here is that there is no evidence that software that is specifically designed and developed to run a particular steel mill in New Zealand is likely to be bought and sold on the open market. I find it difficult to believe that a steel company is some other part of the world would pay anywhere near $33,000,000 for software designed and developed for BHP's steel mill in New Zealand. The uniqueness of the software is illustrated by section 3.0 of the MACC report which reads:
3.0 The Computing Environment in BHP NZS
BHP NZS is New Zealand's largest steel producer employing some 1,900 staff. The company operates an integrated steel mill, comprising iron making plant, steelmaking plant, treatment plant, continuous casting machines, hot strip mill, cold reduction mill, tube and pipe mill and coil coating lines. The company's approach to steel making is different to most in that it uses iron bearing sand as a raw material rather than iron ore. The company exports the majority of its output (approx. 66%) and hence needs to be competitive in the international market place. It does this through being a niche supplier and differentiating itself from major producers by being flexible as to the quantity of a product that can be produced and providing responsive client service. The ability to change schedules and produce small order quantities economically is critical to its competitiveness.
BHP NZS is relatively progressive in its implementation of computerised processing management systems and computer based business systems. The company has prepared a Computer Services Business Plan which outlines how CSD will support the operations of the company from the conversion of the raw material through to the despatch of the finished product. The plan identifies the following 6 levels of computerisation.
Level 5 - Corporate System
Level 4 - Business Support
Level 3 - Process Management
Level 2 - Process Control
Level 1 - Real Time Control
Level 0 - Sensors and Activators
The plan identifies and maps the extent of integration between each level. The knowledge of and adherence to this plan appeared to be well understood and accepted throughout the total organisation. In fact CSD was seen to be a critical element in the overall achievements of the organisations's strategic and annual plans.
While the business and computer information systems had been addressed in the past, the current focus is on computer integrated manufacturing (C.I.M.) which is the horizontal and vertical integration of systems, thereby allowing each level of management access to key data through which decisions, optimisation and continuous improvement can be made.
Full implementation of all C.I.M. systems is planned to lead to further cost reductions, e.g. through inventory reduction and cheaper process costs, because of the increased co-ordination that will be possible between individual plants.
The approach to application development revolves around heavy user involvement in all development activities - in fact for system development projects the delineation between user and CSD staff is hard to determine, so integrated is the team. While there are formally some 55 staff in CSD there are at least 150 staff company wide involved in computer application development and support roles.
The company has adopted an "open system" and distributed processing approach to computer application development using a variety of languages (LINC, ORACLE, FORTRAN) running on multiple hardware platforms (UNISYS, IBM, DEC, SUN). A site wide network based on fibre optics links all processors and facilitates data integration.
[35] I have not reproduced the lengthy section 4.0 (Functional and Technical Evaluation of the Software except for one short passage:
Based on our review the following broad conclusions were formulated regarding the appropriateness and maintainability of the Software:
· While three different programming languages were used for the application development, each language is operationally efficient and well supported. The decision as to which programming language to use was based [on] the hardware platform, nature of processing and likely future technological directions.
· There was a heavy emphasis on user involvement and user responsibility acceptance in most stages of software development. This relationship between CSD and users was one of close co-operation.
· Considerable effort was devoted to alignment of the application requirements with the business needs. This was a substantial factor in ensuring the delivery of effective, supportive and functional applications.
· The Software code appears to be efficiently written and structured to ensure that efficiencies were gained in the overall application development and maintenance tasks.
· An "open" system approach has facilitated the integration of applications whereby data can be transmitted between applications regardless of technical platform.
· Extensive user functions have been incorporated into the Software to support the business operations.
· The Software has been developed using modular programming techniques which aid the system modification of enhancement effect.
· The Software is well documented from a technical and user perspective.
· While not formally documented, industry standards and methodologies current at the time of development appear to have been used in the development process.
· The Software appears to be well maintained with new functionality resulting from user interaction and requests for enhancements and modifications.
· The Software has been developed according to a formal strategic plan which identifies the discrete applications and the extent of (vertical and horizontal) integral/relationship with other applications.
[36] These passages as well as other passages in the report illustrate the excellence of the software in its application to the business of BHP. I accept this conclusion but what it demonstrates is that however valuable it may be to BHP in running its business it could not be readily adapted to anyone else's business. Its very value to BHP is in inverse relationship to its value to another mill and hence would adversely affect what the software would fetch on the open market. Put differently, any company that wanted to install a computer system to run its steel mill would find it easier and cheaper to develop its own system than to pay $33,000,000 or any other amount for BHP's system and then try to adapt it. The more precisely tailored it is to BHP's business and hence the greater its commercial value to BHP, the less useful or valuable it will be to another user.
[37] Faced with the difficulty of finding an open market for the software the MACC report has adopted a valuation method that takes into account replacement cost and historical effort. The following appears in the report:
For the purposes hereof, our conclusions as to the value of the Software at any time represents the price, expressed in terms of money, obtainable for the Software in an open and unrestricted market between informed and prudent parties acting at arm's length and under no compulsion to transact.
This type of wording with slight variations appears in virtually all valuation reports. It is the traditional definition of fmv used by valuators. I do not take exception to it as a definition. It is not however what the MACC report is determining. No open and unrestricted market for software of this type has been identified. That is why replacement cost had to be resorted to as the only available method that would yield a value.
[38] In Aikman v. R., [2000] 2 C.T.C. 2211, affirmed [2002] 2 C.T.C. 147 (F.C.A.) I expressed serious reservations about the use of replacement cost to determine fmv and considered a number of cases where the courts had to determine the fmv of property for which there was no open market. The property there was a disassembled prototype of a lighter-than-air aircraft called the Cyclo-Crane. In that case, however, I had the evidence of a recent arm's length purchase. I do not view the series of purchases for $33,000,000 as affording evidence of fmv.
[39] In this case we have the experts for both parties using replacement cost as an acceptable method of determining fmv and, as Viscount Simon said in the Gold Coast case, one has to do the best one can. Moreover the replacement cost of a property that is developed for use in carrying on a business may be some evidence of fmv in the absence of an open market whereas the replacement cost of a museum artifact with no commercial function is clearly not a reliable test.
[40] Since all the experts agree that replacement cost is an acceptable test and since I have nothing else to go on, I shall deal with the evidence of value on that basis.
[41] The MACC report states:
We have formed an opinion as to the value of the Software using the following valuation methodologies:
· Replacement cost - the value calculated to be the current cost of replacing the Software in terms of design, development together with user training and documentation.
· Historical effort - the effort incurred by BHP NZS in design, development and implementation of the Software.
In determining the value of the Software a two staged approach was adopted, which involved:
· Estimating the value of the Software based on quantitative methods related to replacement cost.
· Adding a factor to replacement cost based on the perceived intellectual knowledge, special skill required to design and develop the Software, its importance to the business operations of the group, and its contribution to earnings.
[42] In his testimony Mr. Cooper stated that the words "and implementation" should be deleted. I agree. The cost of implementation forms no part of replacement cost. However the rest of the evidence of Mr. Cooper does not support the contention that he did not include the cost of implementation.
[43] In determining the replacement cost of the software Mr. Cooper used several methods:
(i) Lines of code. This involves counting the number of lines of operational code (or program statements) and then applying an average number of lines completed per day to arrive at a total number of person days for this application.
(ii) Development time. This involves counting the total time required to perform all activities and tasks associated with the development of the software. Mr. Cooper refers to a book by Capers Jones "Applied Software Measurement" where the observation is made that corporate trading systems accidentally omit 30 percent to 70 per cent of effort in the development of software products. Accordingly he made upward adjustments to take this factor into account.
(iii) Function point analysis. Function points are the weighted sums of five or six different factors such as algorithms, inputs, outputs and so forth and determining how many can be completed per person month.
(iv) Backfire conversion. This is simply a method of verifying the function point analysis by working backwards to the source code.
(v) Estimation formulae. This involves applying formulae to the number of lines of code produced.
I shall not discuss this method further because Mr. Cooper did not consider it reliable and rejected it. I can see why. It resulted in a replacement cost of $58.7 million (NZ), over $10 million higher than the next highest method.
[44] The result of Mr. Cooper's analysis using the various methods is as follows:
Lines of code
- $47,000,000 (NZ)
Development time - $41,100,00 (NZ)
Backfire conversion - $52,000,000 (NZ)
[45] Mr. Cooper, after setting out these numbers, makes a number of comments on the variances. One such observation is the following:
There are variances in value between methods applied across the applications. This demonstrates the volatility of factors used in the calculations.
He concludes that the current replacement cost of the software is NZ$47,000,000. To this he adds another NZ$3,000,000 because of the competitive advantage that the use of the software gives it.
[46] Frankly, one does not need the assistance of an expert to see the fallacy of this reasoning. If you are determining replacement cost you do so by the best method you can. You do not add to the replacement cost that you have determined some arbitrary percentage based on an unrelated factor having to do with how good the product is.
[47] Before I deal with the rebuttal report prepared by the respondent's expert witness there is one piece of evidence that sticks out like a sore thumb. On March 16, 1993 a lawyer acting on behalf of BHP sent a letter to the Commissioner of Inland Revenue of New Zealand setting out the development costs for each application. The figures contained in that letter, as well as those in the MACC report, are as follows: (they were reproduced in Mr. Johnson's report):
Application
Tax Letter
MACC Report
Sales Order Administration ('MARKET')
NZ$
1,230,000
NZ$
6,710,000
Product Design System
725,000
6,380,000
Master Production Scheduling ('MPS')
670,000
3,910,000
Galvanising ('GOSPR')
820,000
3,960,000
Supply System
1,200,000
4,400,000
Financial System Database ('FINSYS')
890,000
4,600,000
Cost Management System ('CMS')
610,000
2,665,000
Rolling Mills Production ('ROLLPC')
1,370,000
5,600,000
Primary Plant Level 3 ('PPL3')
3,000,000
8,165,000
CPD System
675,000
3,800,000
Total
NZ$
11,190,000
NZ$
50,000,000
(rounded)
Conversion Rate to Cdn.$ at the Valuation Date
0.6618
0.6618
Total - Cdn.$
Cdn.$
7,405.823
Cdn.$
33,091.255
[48] In the MACC report reference was made to the Capers Jones book Applied Software Measurement which states that most companies tracking systems do not record between 30 and 70 percent of the real effort that goes into software. These percentages are unsubstantiated and may be arbitrary estimates. Nonetheless, let us accept them and see where they take us.
[49] If we add the lower and higher percentages for slippage to the figures given to the New Zealand tax authorities of NZ$11,190,000 we arrive at figures of NZ$14,587,000 and NZ$19,023,000 respectively or Cdn.$9,627,204 and Cdn.$12,589,421.
[50] I do not intend this calculation to be a stand-alone valuation but it demonstrates how far out of line the MACC report is. Moreover it is consistent with the figures in Mr. Johnson's report.
[51] Mr. Johnson's criticisms of the MACC report are specific and detailed. His conclusions are summarized in a letter to respondent's counsel.
In summary, based on our review and analysis, in our view, the MACC Report's conclusion of NZ$50 million (approximately Cdn.$33 million) for the fair market value of the Software at the Valuation Date likely is significantly overstated. As explained more fully in Appendix A to this letter, the reasons for our view are:
· a letter to the Commissioner of the Inland Revenue Department of New Zealand dated March 16, 1993 wherein BHP New Zealand Steel ('BHP NZS') purports the development cost of the Software to be NZ$11,190,000 (approximately Cdn.$7.4 million); and
· specific issues in the MACC Report, which suggest that its value conclusion is overstated. These include the:
√ inclusion of implementation and training time as a component of replacement cost, which costs do not form part of replacement cost for the Software program itself from the standpoint of Commcorp Financial Services Inc. ('Commcorp'). Such costs may represent between 20% and 35% of the total time expended,
√ daily labour charge rate of NZ$700 adopted by MACC, which may be overstated by 20% to 30%,
√ double-counting of overhead costs relating to management and administrative time, which may overstate the adjustment for 'involvement of non-CSD staff' by 5% to 10%,
√ double-counting of software development time in respect of 'general purpose code' for certain applications, which may overstate the value of the Software by approximately NZ$2 million (approximately Cdn.$1.3 million), and
√ application of a 'business factor' premium, which may overstate the fair market value of the Software to Commcorp by NZ$3 million (approximately Cdn.$2.0 million).
Adjusting for the apparent errors and inconsistencies in the MACC Report based on our analysis, the fair market value of the Software at the Valuation Date falls in the range of approximately NZ$18.5 million to NZ$27.3 million, or approximately Cdn.$12 million to Cdn.$18 million.
Finally, notwithstanding the adjustments that may be appropriate as outlined above, the MACC Report's conclusion that the residual value of the Software 9 years following the Valuation Date is 35% of the initial fair market value (being NZ$17.5 million, or approximately Cdn.$11.6 million) likely is significantly overstated as well.
[52] He supports these conclusions in appendices to the letter. I will not reproduce them here except for the calculation below. I found Mr. Johnson an impressive witness and I accept his conclusions. His recalculation of the fmv of the software is set out in Schedule 2 as follows:
Schedule 2
Recalculation of Fair Market Value of the Software
Low
High
Fair market value per MACC Report
NZ$
50,000,000
NZ$
50,000,000
Business factor premium
(3,000,000)
(3,000,000)
General purpose code
(1,880,000)
(2,115,000)
Sub-total
45,120,000
44,885,000
Management and administrative time
10%
5%
(4,512,000)
(2,244,250)
Sub-total
40,608,000
42,640,750
Average daily labour charge rate
30%
20%
(12,182,400)
(8,528,150)
Sub-total
28,425,600
34,112,600
Implementation and training costs
35%
20%
(9,948,960)
(6,822,520)
Adjusted fair market value
NZ$
18,476,640
NZ$
27,290,080
Conversion Rate to Cdn.$ at the Valuation Date
0.6618
0.6618
Total - Cdn.$ (rounded)
Cdn.$
12,000,000
Cdn.$
18,000,000
[53] The MACC report calculates the residual value of the software at the end of nine years to be 35 percent of its fmv in 1993. The implausibility of this assertion is illustrated in Mr. Johnson's report where he says:
Residual Value Determination
The MACC Report estimates the residual value of the Software at the end of 9 years to be 35% of its 'Assumed Value' (i.e. NZ$17.5 million).
When determining the residual value of the Software, the MACC Report assumes (at Section 8.0) that the Software will not be maintained (or modified by Commcorp). Conversely, in Section 10.0, the MACC Report states that "much of the Software is "state of the art" hence to maintain its competitive advantage and value the Software needs to be continually modified and enhanced to cater for changing requirements and business needs". Accordingly, it seems unrealistic that the Software would retain a significant portion of its original value (35%) 9 years after the Valuation Date, with no maintenance or enhancements, when such things are considered critical by MACC.
The residual value of 35% after 9 years implies an average compound 'physical depreciation' rate of approximately 11% per annum over that period which, in the absence of appropriate maintenance and enhancements, further serves to illustrate the implausibility of MACC's residual value assumption. By way of comparison, at Section 11.0, the MACC Report states that the residual value of the Software at the end of its remaining life (of 12.75 to 12.8 years from the Valuation Date as estimated by MACC) will be approximately 5% of its value at the Valuation Date (in constant dollars). Accordingly, MACC has assumed that the fair market value of the Software will decline at an average annual compound rate of approximately 11% from 1993 through 2002, but then at an average annual compound rate of approximately 40% from 2002 through the end of 2005.
[54] I agree. The idea that software developed in 1993 to run a steel mill would after nine years retain 35 percent of its value strikes me as well beyond the realm of possibility. The fact that the Crown was unable, in 2003, to determine the fmv of the software because of the extensive changes in it over 10 years illustrates how useless it would be without constant upgrading. It is common knowledge that software becomes obsolete very quickly and the evidence here confirms this fact.
[55] Even if we applied the unrealistic percentage of 35 percent to Mr. Johnson's estimate of between $12,000,000 and $18,000,000 (Cdn.) we still end up with $4,200,000 to $6,300,000. This strikes me as high. I do not think that realistically one can justify a figure in excess of 15 percent of the fmv in 1993 and this is probably generous.
[56] The Crown's own expert gives us a fmv in 1993 of between $12 and $18 million (Cdn.). I am not bound to accept this or any other expert opinion and I think that the actual costs of developing the software as supplied to the New Zealand tax authorities are as reliable an indication of the fmv of this property as one is likely to find, at least as a starting point. Therefore, I think the figure of $18,000,000 is too high.
[57] So far as the slippage factor suggested by Capers Jones of between 30 and 70 percent is concerned the 30 percent figure may be realistic whereas the 70 percent factor applied to the BHP figure puts it roughly into the Johnson range of $12,000,000. I think it is fair to give the appellants the benefit of the higher figure which results in a fmv of $13,100,000. I arrive at this figure by adding 70 percent to $7,405,823, the Canadian dollar equivalent of NZ$11,190,000, to arrive at $12,589,899 (Cdn) and rounding it up to Cdn.$13,100,000 which is the figure stated in the Reply to the Notice of Appeal. This is within the range suggested by Mr. Johnson. Thus we have a