Canadian Imperial Bank of Commerce v. Canada

Canadian Imperial Bank of Commerce v. Canada
Court (s) Database
Federal Court of Appeal Decisions
Date
2013-05-06
Neutral citation
2013 FCA 122
File numbers
A-331-12, A-4-12, A-5-12
Notes
Digest
Decision Content
Date: 20130506
Dockets: A-4-12
A-5-12
A-331-12
Citation: 2013 FCA 122
CORAM: EVANS J.A.
SHARLOW J.A.
STRATAS J.A.
Docket: A-4-12
BETWEEN:
CANADIAN IMPERIAL BANK OF COMMERCE
Appellant
and
HER MAJESTY THE QUEEN
Respondent
Docket: A-5-12
AND BETWEEN:
HER MAJESTY THE QUEEN
Appellant
and
CANADIAN IMPERIAL BANK OF COMMERCE
Respondent
Docket: A-331-12
AND BETWEEN:
HER MAJESTY THE QUEEN
Appellant
and
CANADIAN IMPERIAL BANK OF COMMERCE
Respondent
Heard at Toronto, Ontario, on November 21, 2012.
Judgment delivered at Ottawa, Ontario, on May 6, 2013.
REASONS FOR JUDGMENT BY: SHARLOW J.A.
CONCURRED IN BY: EVANS J.A.
STRATAS J.A.
Date: 20130506
Dockets: A-4-12
A-5-12
A-331-12
Citation: 2013 FCA 122
CORAM: EVANS J.A.
SHARLOW J.A.
STRATAS J.A.
Docket: A-4-12
BETWEEN:
CANADIAN IMPERIAL BANK OF COMMERCE
Appellant
and
HER MAJESTY THE QUEEN
Respondent
Docket: A-5-12
AND BETWEEN:
HER MAJESTY THE QUEEN
Appellant
and
CANADIAN IMPERIAL BANK OF COMMERCE
Respondent
Docket: A-331-12
AND BETWEEN:
HER MAJESTY THE QUEEN
Appellant
and
CANADIAN IMPERIAL BANK OF COMMERCE
Respondent
REASONS FOR JUDGMENT
SHARLOW J.A.
[1] In quantifying a taxpayer’s tax liability under the Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.), is it ever necessary to evaluate the morality of the taxpayer’s conduct? As a matter of general principle, the answer should be no. The Income Tax Act is intended to raise revenue for the use of the federal government. It also contains provisions intended to facilitate the distribution of social benefits according to standards established by Parliament, or to encourage or discourage certain industries or commercial practices in the public interest as perceived by Parliament from time to time. But nothing in the Income Tax Act expressly permits or requires the Minister of National Revenue, or the Courts, to apply the Income Tax Act differently depending upon the morality of the taxpayer’s conduct.
[2] Indeed, it has long been accepted in Canada that a taxpayer who conducts an illegal business, or a business conducted unlawfully, is taxable on the profits of that business on the same principles as any other business, except to the extent that a different result is required by a specific provision of the Income Tax Act. Similarly, the Courts have consistently rejected the notion that the Income Tax Act should be interpreted or applied more generously for a taxpayer whose conduct meets a sufficiently high moral standard.
[3] In this case, the Crown takes the position that in determining whether a particular statutory provision (paragraph 18(1)(a) of the Income Tax Act) applies to deny the deduction of a particular expenditure in computing business income for income tax purposes, the Minister (and therefore the Courts) must first determine whether the expense was incurred because of conduct of the taxpayer that was egregious or repulsive. That is so, according to the Crown, because if the answer is yes, then paragraph 18(1)(a) must apply to deny the deduction. The Crown’s position is based on a certain obiter dictum in a decision of the Supreme Court of Canada. For the reasons that follow, I have concluded that the Crown has misinterpreted that obiter dictum and reached a conclusion that is wrong in law.
Introduction
[4] This case involves three appeals from two interlocutory orders of Associate Chief Justice Rossiter of the Tax Court of Canada (2011 TCC 568 and 2012 TCC 237). The orders were made in appeals of reassessments of Canadian Imperial Bank of Commerce (CIBC) under the Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.). Both parties have appealed the first order, which allowed in part CIBC’s motion to strike the Crown’s reply (A-4-12 and A-5-12). The Crown is appealing the second order, which relates to the draft reply submitted by the Crown in its attempt to comply with the first order (A-331-12).
Standard of review
[5] The decision of a judge to grant or refuse a motion to strike is discretionary. This Court will defer to such a decision on appeal in the absence of an error of law, a misapprehension of the facts, a failure to give appropriate weight to all relevant factors, or an obvious injustice: Apotex Inc. v. Canada (Governor in Council), 2007 FCA 374, Collins v. Canada, 2011 FCA 140.
Statutory framework for the motions
[6] CIBC’s motion to strike relied on Rule 53 of the Rules of the Tax Court of Canada (General Procedure), SOR/90-688a, which reads as follows:
53. The Court may strike out or expunge all or part of a pleading or other document, with or without leave to amend, on the ground that the pleading or other document,
53. La Cour peut radier un acte de procédure ou un autre document ou en supprimer des passages, en tout ou en partie, avec ou sans autorisation de le modifier parce que l’acte ou le document :
(a) may prejudice or delay the fair hearing of the action,
(b) is scandalous, frivolous or vexatious, or
(c) is an abuse of the process of the Court.
a) peut compromettre ou retarder l’instruction équitable de l’appel;
b) est scandaleux, frivole ou vexatoire;
c) constitue un recours abusif à la Cour.
[7] There is no dispute as to the general test for striking pleadings. It was recently restated in R. v. Imperial Tobacco Canada Ltd., 2011 SCC 42, [2011] 3 S.C.R. 45 at paragraph 17. In the context of a motion to strike the Crown’s reply in an income tax appeal, the motion will be granted only if it is plain and obvious, assuming the facts as pleaded in the reply are true, that the reply fails to state a reasonable basis for concluding that the reassessment under appeal is correct.
Factual background and procedural history
[8] Four proceedings in the Tax Court have given rise to these appeals. They are all appeals by CIBC of reassessments made under the Income Tax Act, each relating to a different taxation year of CIBC (2002, 2003, 2005, and 2006) relating to the same transactions. CIBC raises the same issues in each appeal. The Crown’s replies are similar, as are CIBC’s motions to strike the replies.
[9] In the Tax Court, argument on the motions was focused on the Crown’s reply for 2002 on the understanding that the same result would apply for the other three years. Similarly, the appeals now before this Court deal only with the Crown’s reply for 2002, but by agreement the disposition of this appeal will apply to the other three years.
[10] The main issue in all four income tax appeals is the deductibility of approximately $3 billion in computing CIBC’s business income. Most of that amount consists of payments made by CIBC to settle litigation that arose after the bankruptcy of Enron Corporation. The remainder consists of interest and legal expenses relating to the settlement payments. For the purposes of this appeal, it is necessary to consider only the settlement payments.
[11] The litigation that resulted in the settlement payments arose in connection with certain transactions involving Enron and CIBC and its affiliates which, for reasons that will become apparent, CIBC refers to as the “CIBC FAS 125/140 Transactions”. In these reasons, it is more convenient to refer to them as the “Transactions”.
[12] “FAS 125” and “FAS 140” are United States accounting standards. It appears that at this stage of the proceedings there are three items of common ground relating to FAS 125 and FAS 140. First, FAS 125 and FAS 140 state the conditions that must be met before a transaction may be treated as an asset sale in published financial reports. Second, Enron was obliged to follow FAS 125 and FAS 140 in its financial reporting. Third, Enron filed its financial reports on the basis that the Transactions were asset sales that met the requirements of FAS 125 and FAS 140.
[13] Whether the Transactions actually met the requirements of FAS 125 and FAS 140 became a matter of controversy. That controversy led to lawsuits against Enron in the United States. Two of those lawsuits, the “Newby Litigation” and the “MegaClaim Litigation”, were based on the allegation that Enron mischaracterized the Transactions as asset sales in its financial reports contrary to the requirements of FAS 125 and FAS 140. It was alleged that because of that mischaracterization, Enron’s debts were understated and the financial reports were materially misleading, which caused the complainants to suffer losses for which Enron was liable.
[14] CIBC was named as a defendant in both lawsuits. The complainants alleged that CIBC or affiliates of CIBC financed the Transactions with the intention of earning fees and achieving desirable recognition from Enron as a source of financing. They also alleged that CIBC or its affiliates took part in the Transactions with sufficient knowledge of the affairs of Enron to render it jointly and severally liable with Enron and other defendants for the losses suffered by the complainants because of Enron’s misleading financial reports.
[15] Pursuant to the agreements under which the settlement payments were made, the claims against CIBC and its affiliates were discharged with no admission of wrongdoing or liability. CIBC alleges that the settlement payments enabled CIBC to avoid becoming jointly and severally liable with numerous other defendants in the litigation, as well as the adverse effects of ongoing litigation (CIBC notice of appeal, paragraph 3). CIBC also alleges that it considered the settlement to be legally and commercially prudent (CIBC notice of appeal, paragraphs 16 and 21).
[16] The settlement payments were deducted in computing CIBC’s profit for financial statement purposes and for income tax purposes. CIBC alleges that these deductions accord with Canadian generally accepted accounting principles (“GAAP”), and also that they accord with sections 3 and 9 of the Income Tax Act (CIBC notice of appeal, paragraphs 4, 23, and 32).
[17] The Minister reassessed to disallow the deduction of the settlement payments. CIBC objected without success. The Minister confirmed the reassessments on the basis of paragraphs 18(1)(a), (b) and (e) of the Income Tax Act (CIBC notice of appeal, paragraph 26). CIBC appealed to the Tax Court on the basis that the deduction accords with sections 3 and 9, and is not prohibited by 18(1)(a), (b) or (e) of the Income Tax Act.
[18] The subject of CIBC’s motion to strike is the Crown’s amended reply filed on September 30, 2010. In that reply, the Crown defends the correctness of the reassessment on a number of alternative bases.
[19] Most of the grounds stated in the Crown’s reply are not in issue in this appeal. Therefore, regardless of the outcome of this appeal, it appears at this stage of the pleadings that the Crown will be entitled to argue that the deduction of the settlement payments was properly disallowed in whole or in part for any of the following reasons:
(a) the settlement payments were not made or incurred by CIBC for the purpose of earning income from its business (paragraph 18(1)(a) – paragraph 133 of the reply);
(b) the settlement payments were made or incurred by CIBC on behalf of one or more of CIBC’s affiliates (paragraph 135 of the reply);
(c) the settlement payments were outlays or payments on account of capital (paragraph 18(1)(b) – paragraph 136 of the reply);
(d) the terms or conditions made or imposed in respect of securing releases on behalf of CIBC affiliates differed from those that would have been made between persons dealing at arm’s length so that 93% of the settlement payments are not deductible (subsection 247(2) – paragraph 137 of the reply);
(e) the settlement payments were contingent liabilities in the years the deductions were claimed (paragraph 18(1)(e) – paragraph 138 of the reply); or
(f) the settlement payments were not outlays or expenses that were reasonable in the circumstances (section 67 – paragraph 139 of the reply).
[20] CIBC’s motion to strike relates primarily to paragraph 134 of the reply, which invokes paragraph 18(1)(a). Paragraph 134 reads as follows:
134. The misconduct of [CIBC and its affiliates] was so egregious and repulsive that any consequential settlement payments […] cannot be justified as being incurred for the purpose of gaining or producing income from a business or property within the meaning of paragraph 18(1)(a) of the [Income Tax] Act. The [CIBC affiliates] knowingly aided and abetted Enron to violate the United States’ federal securities laws and falsify its financial statements. The misconduct of [the CIBC affiliates] in enabling Enron to perpetrate its frauds, known to [CIBC], or the misconduct of [CIBC] itself, was so extreme, and the consequences so dire, that it could not be part of the business of a bank.
[21] CIBC argues that paragraph 134 of the reply fails to state a reasonable basis for concluding that the reassessment under appeal is correct. I summarize CIBC’s reasoning as follows. The Crown is entitled to defend the reassessment under appeal on the basis of paragraph 18(1)(a) by alleging facts in support of its position that CIBC did not make the settlement payments for the purpose of earning income from its business. However, as a matter of law, the interpretation and application of paragraph 18(1)(a) cannot turn on a moral evaluation of the conduct of CIBC as alleged in the pleadings filed by the plaintiffs in the Newby Litigation and the MegaClaim Litigation. It follows that even if the conduct of CIBC is accurately described in the unproven allegations made in that litigation, which have been adopted by the Minister as factual assumptions and have been separately pleaded as factual allegations, the Crown’s characterization of that conduct as “egregious and repulsive” is not relevant to the correct interpretation or application of paragraph 18(1)(a). Therefore paragraph 134 of the reply, as well as all factual allegations in the reply that characterize the alleged conduct of CIBC as egregious or repulsive, meet one or more of the tests in Rule 53 for the striking of pleadings, and should be struck.
[22] The Crown argues that paragraph 134 of its reply embodies a legal principle found in paragraph 69 of 65302 British Columbia Ltd. v. Canada, [1999] 3 S.C.R. 804 (referred to as the “Egg Case” because the taxpayer was an egg producer). I discuss that case later in these reasons.
First decision of the Tax Court – motion to strike granted in part (December 21, 2011)
[23] The judge concluded that it is not plain and obvious that the Crown’s theory as embodied in paragraph 134 of its reply cannot succeed. On that basis, he dismissed the portion of CIBC’s motion to strike that dealt with that issue. CIBC has appealed to this Court to challenge that conclusion (A-4-12). The judge also concluded that there were other improprieties in the reply, particularly in the statement of the Minister’s assumptions. The Crown takes issue with some of those conclusions. That is the subject of the Crown’s appeal (A-5-12). In the discussion below, I discuss the two appeals separately.
CIBC appeal of first decision (A-4-12)
[24] CIBC argues that the judge erred in law when he concluded that paragraph 134 of the reply states a reasonable basis for defending the reassessments. Paragraph 134 is quoted above but I repeat it here for ease of reference:
134. The misconduct of [CIBC and its affiliates] was so egregious and repulsive that any consequential settlement payments […] cannot be justified as being incurred for the purpose of gaining or producing income from a business or property within the meaning of paragraph 18(1)(a) of the [Income Tax] Act. The [CIBC affiliates] knowingly aided and abetted Enron to violate the United States’ federal securities laws and falsify its financial statements. The misconduct of [the CIBC affiliates] in enabling Enron to perpetrate its frauds, known to [CIBC], or the misconduct of [CIBC] itself, was so extreme, and the consequences so dire, that it could not be part of the business of a bank.
[25] As mentioned above, CIBC alleges in its notice of appeal that the deduction of the settlement payments accords with GAAP and with sections 3 and 9 of the Income Tax Act. Those provisions read in relevant part as follows:
3. The income of a taxpayer for a taxation year for the purposes of this Part is the taxpayer’s income for the year determined by the following rules:
3. Pour déterminer le revenu d’un contribuable pour une année d’imposition, pour l’application de la présente partie, les calculs suivants sont à effectuer :
(a) determine the total of all amounts each of which is the taxpayer’s income for the year […] from a source […] including, without restricting the generality of the foregoing, the taxpayer’s income for the year from each […] business […].
a) le calcul du total des sommes qui constituent chacune le revenu du contribuable pour l’année […] dont la source […] sans que soit limitée la portée générale de ce qui précède, le revenu tiré de chaque […] entreprise […].
[…]
[…]
9. (1) Subject to this Part, a taxpayer’s income for a taxation year from a business […] is the taxpayer’s profit from that business […] for the year.
9. (1) Sous réserve des autres dispositions de la présente partie, le revenu qu’un contribuable tire d’une entreprise […] pour une année d’imposition est le bénéfice qu’il en tire pour cette année.
[26] Section 3 sets out the formula for determining a taxpayer’s income for the year for income tax purposes. Pursuant to paragraph 3(a), one component of a taxpayer’s income is income from a business of the taxpayer.
[27] According to subsection 9(1), a taxpayer’s income for a year from a business is the taxpayer’s profit for the year from that business. Generally, an amount that is deductible in computing profit under well accepted business principles (which includes “generally accepted accounting principles” or “GAAP” as adopted by the Canadian accounting profession) is deductible in computing business income for income tax purposes (Canderel Ltd. v. Canada, [1998] 1 S.C.R. 147 at paragraph 53).
[28] However, that general proposition is qualified by the phrase “subject to this Part” at the beginning of subsection 9(1). That phrase refers to Part I of the Income Tax Act which contains, among other things, many prohibitions on deductions. Most of those prohibitions appear in sections 18 and 67 of the Income Tax Act.
[29] Paragraph 134 of the reply cites paragraph 18(1)(a) of the Income Tax Act as the statutory basis for disallowing the deduction of the settlement payments. The Minister assumed that the conduct of CIBC that led to the Newby Litigation and the MegaClaim Litigation is accurately stated in the plaintiffs’ pleadings in those cases. The position of the Crown is that the assumed conduct of CIBC was “egregious and repulsive”, which is a sufficient basis for applying paragraph 18(1)(a) to disallow the deduction of any expense incurred by CIBC to settle the litigation. Paragraph 18(1)(a) is paraphrased above, but I quote it here:
18. (1) In computing the income of a taxpayer from a business […] no deduction shall be made in respect of
18. (1) Dans le calcul du revenu du contribuable tiré d’une entreprise […], les éléments suivants ne sont pas déductibles :
(a) an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business […];
a) les dépenses, sauf dans la mesure où elles ont été engagées ou effectuées par le contribuable en vue de tirer un revenu de l’entreprise […] ;
[30] In support of the Crown’s theory as embodied in paragraph 134 of the reply, the Crown relies on the following obiter dictum from paragraph 69 of the reasons of Justice Iacobucci, writing for the majority in the Egg Case:
It is conceivable that a breach [of the law] could be so egregious or repulsive that the fine subsequently imposed could not be justified as being incurred for the purpose of producing income.
[31] The Egg Case was important when it was decided in 1999 because it settled a debate rooted in two competing theories about the application of the statutory income earning purpose test in relation to fines and penalties. Typically, the Crown would argue that to allow the deduction of a fine or penalty as a business expense undermines the public policy objective of the imposition of the fine or penalty, and for that reason the deduction should be denied pursuant to paragraph 18(1)(a). The competing theory, typically proposed by the taxpayer, was that in matters of fiscal law, it is for Parliament and not the Courts to determine public policy. In the Egg Case, the majority of the Supreme Court of Canada adopted the taxpayer’s theory and rejected the Crown’s theory.
[32] In 2005, Parliament addressed the public policy of the deduction of fines and penalties by enacting section 16 of the Budget Implementation Act, 2004, No. 2, S.C. 2005, c. 19. That provision amended the Income Tax Act to prohibit the deduction of fines and penalties imposed after March 22, 2004. The prohibition is now in section 67.6 of the Income Tax Act, which reads as follows:
67.6 In computing income, no deduction shall be made in respect of any amount that is a fine or penalty (other than a prescribed fine or penalty) imposed under a law of a country or of a political subdivision of a country (including a state, province or territory) by any person or public body that has authority to impose the fine or penalty.
67.6 Aucune déduction ne peut être faite dans le calcul du revenu au titre de toute amende ou pénalité (sauf celles visées par règlement) imposée sous le régime des lois d’un pays, ou d’une de ses subdivisions politiques — notamment un État, une province ou un territoire — par toute personne ou tout organisme public qui est autorisé à imposer pareille amende ou pénalité.
[33] This is not the only example of a statutory prohibition on the deductibility of certain payments based on public policy considerations. The Income Tax Act had previously been amended to add subsection 67.5(1), which prohibits the deduction of any payment made for the purpose of doing anything that is an offence under section 3 of the Corruption of Foreign Public Officials Act, S.C. 1998, c. 34, or under any of sections 119 to 121, 123 to 125, 393 and 426 of the Criminal Code, R.S.C. 1985, c. C-46, or an offence under section 465 of the Criminal Code as it relates to an offence described in any of those sections.
[34] After the enactment of section 67.6, the Egg Case no longer determined the deductibility of fines and penalties. However, the Egg Case continues to be important because it determines the correct interpretation and application of paragraph 18(1)(a) of the Income Tax Act, and therefore it is potentially applicable to the deduction of expenses other than fines and penalties. For example, in McNeill v. Canada, [2000] 4 F.C. 132 (C.A.), it was held (at paragraph 14) that the reasoning in the Egg Case applies where an issue is raised as to the deductibility of damages for breach of contract (McNeill is discussed below).
[35] To understand the Egg Case, it is useful to understand the jurisprudence that preceded it. The starting point for my review of the jurisprudence is Commissioners of Inland Revenue v. Alexander von Glehn & Co., Ltd., [1920] 2 K.B. 553 (C.A.). The Crown has cited that case many times in support of the proposition, stated in various ways, that in determining the deductibility of an expense incurred because of the taxpayer’s unlawful or wrongful conduct, it is relevant to consider matters of public policy that are not necessarily suggested by the language of paragraph 18(1)(a) (or one of its many statutory predecessors).
[36] The issue in von Glehn was the deductibility of a penalty imposed on an exporter for not taking sufficient care during the war to ensure that its exports did not reach an enemy country. The penalty was found not to be deductible because of a statutory test that is somewhat like paragraph 18(1)(a) (but more narrowly worded) on the basis that the penalty could not have served any profit making purpose. But in obiter dicta, the judges made the following comments:
Lord Sterndale MR: This business could perfectly well be carried on without any infraction of the law at all. […] It is perhaps a little difficult to put the distinction into very exact language, but there seems to me to be a difference between a commercial loss in trading and a penalty imposed upon a person or company for a breach of the law which they have committed in that trading.
Warrington LJ: Now it cannot be said that the disbursement in the present case is made in any way for the purpose of the trade or for the purpose of earning the profits of the trade. The disbursement is made, as I have already said -- and the same remark applies to this Rule as to the other -- because the individual who is conducting the trade has, not from any moral obliquity, but has unfortunately, been guilty of an infraction of the law.
Scrutton LJ: I am inclined to think, though I do not wish finally to decide it, that the Income Tax Acts are to be confined to lawful businesses, and to businesses carried on in a lawful way.
[37] As will become apparent from the discussion below, the authority of von Glehn was diminished in 1927 by the decision of the Judicial Committee of the Privy Council in Minister of Finance v. Smith, [1927] A.C. 193, sub. nom. Reference re Income War Tax Act, 1917 (Can.). In 1999, the Egg Case rendered von Glehn insignificant.
[38] The Smith case was a reference to the Judicial Committee relating to the Income War Tax Act, 1917, S.C. 1917, c. 28, the earliest predecessor to the Income Tax Act. The question was whether it was lawful for Canada to impose tax on the profits of a liquor trading business carried on in contravention of the Ontario prohibition law. The answer was yes. Lord Haldane, speaking for the Judicial Committee, said this (at page 197, my emphasis):
Construing the Dominion Act literally, the profits in question, although by the law of the particular Province they are illicit, come within the words employed. […]. There is nothing in the Act which points to any intention to curtail the statutory definition of income, and it does not appear appropriate under the circumstances to impart any assumed moral or ethical standard as controlling in a case such as this the literal interpretation of the language employed. There being power in the Dominion Parliament to levy the tax if they thought fit, their Lordships are therefore of the opinion that it has levied income tax without reference to the question of Provincial wrongdoing.
[39] Smith established the proposition, which is still good law, that the profit of an unlawful business is taxable in exactly the same manner as the profit of a lawful business. In reaching that conclusion, the Judicial Committee considered von Glehn. Without doubting the result in that case in respect of the income earning purpose test as it then read, the Judicial Committee rejected the suggestion of Scrutton LJ that fiscal laws apply only to lawful businesses or businesses carried on in a lawful way.
[40] After Smith, there were many cases dealing with the deductibility of an expense incurred because of the unlawful conduct of the taxpayer. Typically, the deduction was sought for a fine or penalty, or legal expenses incurred to defend against the imposition of a fine or penalty. The most frequently cited examples are summarized below.
[41] In Rolland Paper Co. v. Canada (Minister of National Revenue), [1960] Ex. C.R. 334, Justice Fournier concluded that a paper manufacturer was entitled to deduct the legal expenses it incurred in an unsuccessful appeal of its conviction for an unlawful trading practice, which at the time was a criminal offence. As part of the analysis, Justice Fournier considered whether the fact that a business is conducted unlawfully is relevant to the application of the statutory income earning purpose test in the predecessor to paragraph 18(1)(a). After referring to von Glehn and Smith, he concluded that such illegality is not relevant. He explained his conclusion as follows at pages 338 to 340:
So, the trial judge who had found the appellant guilty thought that he should not look upon it as guilty of moral turpitude or of wicked intention. There had been a breach of a statute and the appellant was responsible for its unlawful act. That being the case, it becomes necessary to determine if unlawful acts committed in earning income from the operations of a business or trade are to be considered in computing the income of a taxpayer. The Act clearly states that the income of a taxpayer is his income from all sources. It is a sweeping and positive statement and it has been constantly held that income tax is a tax upon the person measured by his income and that the source of his income should not be looked at when computing a taxpayer's taxable income.
[…]
[…] It would seem that the income tax provisions are applicable to taxpayers carrying on business by means of unlawful practices […] unless specifically prohibited by the Income Tax Act. Were it to be otherwise, it would be most difficult to bring within the ambit of the taxation statute taxpayers responsible for such unlawful practices. In the present instance, the appellant, though charged and later found guilty of the unlawful business practice supra, did report in its income tax return for its taxation year its income from its business in that year, in compliance with s. 3(a) of the Act. But in reporting its income, to arrive at the amount of its taxable income – s. 2(3) – it sought to deduct legal costs incurred and paid in defending its business practices. The only change to the appellant's income tax return made by the respondent was his refusal to allow the above sought deduction. No doubt was ever raised as to the respondent's right to impose and levy income tax on the appellant's taxable income from its business whether or not the income flowed from unlawful practices. But the tax to be levied is not on the taxpayer’s income; it is on his income minus the deductions permitted by the Act. […]
[42] This passage highlights the essential problem with prohibiting the deduction of an expense solely because it was incurred because of the taxpayer’s unlawful conduct. To prohibit the deduction of such an amount, if in fact it was incurred for a profit making purpose, would contradict the fundamental principle that a business profit is the revenue of a business less the expenses incurred to earn the revenue.
[43] However, because Justice Fournier noted in Rolland Paper (at page 338) that the taxpayer was not “guilty of moral turpitude or of wicked intention”, some cases after Rolland Paper suggest that there may be circumstances in which an expense, even if incurred for a profit making purpose, might be found not to be deductible if the taxpayer’s conduct falls below a certain moral standard.
[44] In Canada (Minister of National Revenue) v. E.H. Pooler and Co., [1963] Ex. C.R. 16, the issue was whether a firm of stockbrokers was entitled to deduct a fine imposed by the Board of Governors of the Toronto Stock Exchange. An employee of the firm had induced other brokerage firms to open accounts for certain individuals who then engaged in improper margin trading. The Board, after an investigation, concluded that the employee’s acts were detrimental to the Exchange. Under the rules of the Exchange, the conduct of a firm’s employee was attributed to the firm. Justice Thurlow concluded that for two reasons, the fine was not an expense that met the statutory income earning test in the applicable predecessor to paragraph 18(1)(a). First, the firm was liable to pay the fine whether or not it continued to carry on its brokerage business. Second, the conduct of the employee that resulted in the fine was not part of the business of the firm and could not possibly have produced any profit for the firm. In respect of the second reason, Justice Thurlow said (at page 22) that there “may or may not” be a “broader principle” that could justify disallowing the deduction, but he did not elaborate.
[45] Minister of National Revenue v. Eldridge, [1965] 1 Ex. C.R. 758, is the first case dealing with the tax implications of an illegal business in which no comment was made about the morality of the taxpayer’s conduct or the need to consider the public policy reason for the law against the business. Justice Cattanach concluded that the operator of an unlawful call girl business was entitled to deduct the expenses incurred in earning the profits of that business. The only expenses for which a deduction was not permitted were those that could not be substantiated with documentary evidence (including amounts that the taxpayer claimed to have paid the police for protection), and the cost of a bail bond for herself. Among the permissible deductions were the expenses incurred in obtaining bail bonds for her employees, legal expenses paid to defend her employees from criminal charges, the cost of hiring individuals to provide physical protection for her employees, and rent paid for the premises used by her employees.
[46] Day & Ross Limited v. Her Majesty the Queen, [1977] 1 F.C. 780 (T.D.), involved numerous issues, but for the purposes of this appeal the only one of interest is whether a trucking company was entitled to a deduction for fines imposed for exceeding load restrictions set by provincial laws. The Crown argued that the fines were not deductible because of the “broader principle” mentioned in Pooler, which the Crown identified as the common law principle that “criminals should not benefit from their crimes” (page 793). That argument apparently was a paraphrase of the maxim sometimes expressed as “ex turpi causa non oritur actio”, which means that a person’s own dishonourable (or wrongful or unlawful) conduct cannot be the basis of a legal claim. The taxpayer argued that “the legality or illegality of the business to which the expense relates is irrelevant in interpreting the Income Tax Act” (page 793).
[47] Justice Dubé did not accept or reject either argument in principle. He did, however, suggest that there might be some merit in the Crown’s argument when he seems to describe (at page 791) a two part test for the deductibility of a fine:
The first determination must be as to whether or not the payment of the fines constituted an outlay made for the purpose of producing income for the plaintiff so as to meet the requirement of the exception to the prohibition of [paragraph 18(1)(a)]. If the determination is affirmative, then the argument of public interest must be met.
[48] Justice Dubé concluded that the fines were deductible because they resulted from the day-to-day operation of the taxpayer’s transport business and were paid as a necessary expense of that business. He explained this conclusion as follows at page 794:
In the absence of constant control by the plaintiff over the exact cargo weight carried in its trailers, and the uncontradicted evidence would suggest that such a tight control would be impractical if not impossible in a very highly competitive road transport industry, then unintentional violations of weight restrictions would seem to be inevitable. Plaintiff's method of bookkeeping, with fines paid entered as expense and fines recovered from customers booked as revenue, would also indicate that the payment of fines was very much a current item in the operation of plaintiff's business. The ready availability of advance overweight permits at the request of a shipper would also tend to show that weight restrictions can be easily overcome and that violations thereof are obviously not outrageous transgressions of public policy.
[49] TNT Canada Inc. v. Canada (1988), 20 F.T.R. 214 (T.D.), also involved the deductibility of penalties imposed on a trucking company, but the penalties were imposed under the Excise Tax Act, R.S.C. 1985, c. E-15, and the Customs Act, R.S.C. 1985, c. 1 (2nd Supp.), for having repair work done in the United States without paying the applicable sales and excise tax, and for making too many stops in Canada for a foreign carrier. Justice Cullen reasoned that von Glehn was authority for the general principle that fines and penalties are not deductible, but because of the two-part test in Day & Ross, there was an exception for fines and penalties that result from the day to day operation of the taxpayer’s business and are a necessary expense. He concluded that the deduction of the penalties in the case before him should not be denied in this case on grounds of public policy, since there were only a small number of offences compared to the 80,000 dispatches in the year. However, the deduction was denied for a different reason (the deduction was claimed in 1980, but the penalties had been imposed in 1979 and paid in 1981).
[50] In Amway of Canada, Ltd. v. Canada (1996), 193 N.R. 381 (F.C.A.), this Court followed the approach in Day & Ross and TNT in a different factual context. The taxpayer in Amway was found to have falsified the value of goods imported into Canada in the years 1974 to 1980 in an attempt to avoid duty and excise taxes. The goods had been undervalued by approximately $84 million, and the total tax sought to be avoided was approximately $30 million. The taxpayer was assessed for the tax, as well as civil penalties. The Crown attempted to collect the tax and civil penalties through actions in the Federal Court. Eventually all of the actions were settled for a single payment of $45 million, of which $37.1 million was found to represent the amount paid to settle the Crown’s claim for the civil penalties. The issue was whether the $37.1 million payment was deductible.
[51] Generally, a payment made to settle a civil claim is deductible if the claim is for an amount that would have been deductible if paid. Under that principle, the $37.1 million payment made to settle the claim for the penalties would be deductible if the penalties were deductible. Accordingly, the issue was the deductibility of the penalties. Justice Strayer, writing for the Court, cited with approval the reasoning in von Glehn, Day & Ross and TNT, and concluded that a penalty is deductible as a business expense if it is unavoidable, in the sense that the penalty is a normal and ordinary risk and incidental to the business. He found that this test was not met for the Amway penalties because they were incurred as the result of an “intentional and cynical scheme to mislead Canadian customs officials as to the value of goods” (paragraph 31).
[52] Justice Strayer also gave a second reason for finding the penalties not to be deductible. This is explained as follows at paragraph 32 of his reasons:
32. […] Secondly, in my view it is contrary to public policy to allow the deduction of a fine or penalty as a business expense where that fine or penalty is imposed by law for the purpose of punishing and deterring those who through intention or a lack of reasonable care violate the laws. In a case such as the present the penalties are fixed by statute […]. It would frustrate the purposes of the penalties imposed by Parliament if after paying those penalties exigible by law a taxpayer were then able to share the cost of that penalty - and the higher his marginal rate of taxation the more he could share - with other taxpayers of Canada by treating it as a deductible expense and thus reducing his taxable income. Such a result would, I believe, clearly be contrary to public policy.
[53] Amway was the leading authority on the deductibility of fines and penalties until the Supreme Court of Canada rendered its decision in the Egg Case, to which I now turn.
[54] As mentioned above, the Crow